What Is an Exchange Fund?
An exchange fund, also known as a swap fund, is an arrangement between concentrated shareholders of different companies that pools shares and allows an investor to exchange their large holding of a single stock for units in the entire pool's portfolio. Exchange funds provide investors with an easy way to diversify their holdingswhile deferring taxes from capital gains.
Exchange funds should not be confused with exchange traded funds (ETFs), which are mutual fund-like securities that trade on stock exchanges.
Key Takeaways
- Exchange funds pool large amounts of concentrated shareholders of different companies into a single investment pool.
- The purpose is to allow large shareholders in a single corporation to exchange their concentrated holding in exchange for a share in the pool's more diversified portfolio.
- Exchange funds are particularly appealing to concentrated shareholders who wish to diversity their otherwise restricted holdings.
- They also appeal to large investors who have highly appreciated stock that would be subject to large capital gains taxes if they sought to diversify by selling those shares to purchase others in the market.
How Exchange Funds Work
Theexchange fundtakes advantage of there being a number of investors in similar positions: holding concentrated stock positions and wishing to diversify. Several investors pool their shares into apartnership, and each receives a pro-rata share of the exchange fund. Now the investor owns a share of a fund that contains a portfolio of different stocks—which allows for some diversification. This approach not only achieves a measure of diversification for the investor, but it also allows for the deferral of taxes.
Because an investor swaps shares with the fund, no sale actually occurs. This allows the investor to defer the payment of capital gains taxes until the fund's units are sold. There are both private and public exchange funds. The former provides investors with a way to diversify private equity holdings, while the latter offer shares containing publicly traded firms.
Exchange funds are designed to appeal primarily to investors who previously focused on building concentrated positions on restricted or highly appreciated stock, but who are now looking to diversify. Typically, a large bank, investment company, or other financial institution will create a fund, targeting a certain size and blend in terms of the stock that is contributed.
Participants in an exchange fund will contribute some of the shares they hold, which are then pooled with other investors’ shares. With each shareholder that contributes to it, the portfolio becomes increasingly diversified. An exchange fund may be marketed towardexecutives and business owners, who have amassed positions that typically are centered on one or a handful of companies. Participating in the fund allows them to diversify those heavily concentrated positions of stocks.
Exchange Fund Requirements
Exchanged funds may require potential participants to have a minimum liquidity of $5 million cash to join and contribute. Exchange funds will also typically have a seven-yearlock-up periodto satisfy the tax deferral requirements, which could pose a problem for some investors.
As the fund grows, and when enough shares have been contributed, the fund closes to new shares. Then, each investor is given interest in the collective shares based on their portion from the original contributions. The shares in the fund moved to the exchange fund are not immediately subject to capital gains taxation.
If an investor decides they wish to leave, they will receive shares drawn from the fund rather than cash. Those shares will be dependent on what has been contributed to the fund and is still available. Up to 80 percent of the assets in an exchange fund can be stocks, but the rest must be made up of illiquid investments, such as real estate investments.
FAQs
An exchange fund is a tax-efficient private fund owned by investors who exchange their individual stock for shares in the fund. Exchange funds only accept “in-kind” stock contributions, not money.
What are the tax advantages of exchange funds? ›
Exchange funds provide investors with an easy way to diversify their holdings while deferring taxes from capital gains. Exchange funds should not be confused with exchange traded funds (ETFs), which are mutual fund-like securities that trade on stock exchanges.
How are exchange traded funds taxed? ›
Dividends and interest payments from ETFs are taxed similarly to income from the underlying stocks or bonds inside them. For U.S. taxpayers, this income needs to be reported on form 1099-DIV. 2 If you earn a profit by selling an ETF, they are taxed like the underlying stocks or bonds as well.
What are exchange traded funds advantages and disadvantages? ›
In addition, ETFs tend to have much lower expense ratios compared to actively managed funds, can be more tax-efficient, and offer the option to immediately reinvest dividends. Still, unique risks can arise from holding ETFs as well as tax considerations, depending on the type of ETF.
What are tax advantage funds? ›
What Is Tax-Advantaged? The term tax-advantaged refers to any type of investment, financial account, or savings plan that is either exempt from taxation, tax-deferred, or that offers other types of tax benefits.
Do you pay taxes when you exchange funds? ›
Just as with individual securities, when you sell shares of a mutual fund or ETF (exchange-traded fund) for a profit, you'll owe taxes on that "realized gain." But you may also owe taxes if the fund realizes a gain by selling a security for more than the original purchase price—even if you haven't sold any shares.
Which ETF is most tax-efficient? ›
Top Tax-Efficient ETFs for U.S. Equity Exposure
- iShares Core S&P 500 ETF IVV.
- iShares Core S&P Total U.S. Stock Market ETF ITOT.
- Schwab U.S. Broad Market ETF SCHB.
- Vanguard S&P 500 ETF VOO.
- Vanguard Total Stock Market ETF VTI.
ETFs are subject to market fluctuation and the risks of their underlying investments. ETFs are subject to management fees and other expenses. Unlike mutual funds, ETF shares are bought and sold at market price, which may be higher or lower than their NAV, and are not individually redeemed from the fund.
What is an ETF for dummies? ›
A cross between an index fund and a stock, they're transparent, easy to trade, and tax-efficient. They're also enticing because they consist of a bundle of assets (such as an index, sector, or commodity), so diversifying your portfolio is easy. You might have even seen them offered in your 401(k) or 529 college plan.
How do you make money from ETFs? ›
Traders and investors can make money from an ETF by selling it at a higher price than what they bought it for. Investors could also receive dividends if they own an ETF that tracks dividend stocks. ETF providers make money mainly from the expense ratio of the funds they manage, as well as through transaction costs.
Index funds—whether mutual funds or ETFs (exchange-traded funds)—are naturally tax-efficient for a couple of reasons: Because index funds simply replicate the holdings of an index, they don't trade in and out of securities as often as an active fund would.
What is a tax-advantaged account with tax-free withdrawals? ›
Roth IRA. Contributions you make to a Roth IRA are made after tax—meaning you don't get a tax break in the current year. However, the funds grow tax free. Withdrawals you make in retirement are also tax free, as long as you meet the criteria for qualified distributions.
Are tax-advantaged accounts worth it? ›
Tax-advantaged accounts, such as an IRA, 401(k), or Roth IRA, are generally a better home for investments that lose more of their returns to taxes.
How is JEPI taxed? ›
JEPI uses Equity Linked Notes (ELNs) to generate monthly income for their investors. In the eyes of the IRS , the income generated by these ELNs are taxed as ordinary income -- meaning after taxes, this 9.8% figure might be materially lower for some folks depending on their tax brackets.
Is a schd tax efficient? ›
Since both VOO and SCHD are ETFs, they have the same characteristics when it comes to tax efficiency, tax loss harvesting, and minimum investment requirements. Overall, if you are looking for an ETF that generates high dividends, then SCHD is the better option.
Can you exchange mutual fund for ETF without paying taxes? ›
Please note that when you convert your current asset base into an ETF you do not ELIMINATE taxes, you simply carry over your basis from your underlying investments, and your old basis is now the basis in your ETF shares.
How are crypto ETFs taxed? ›
Bitcoin ETFs follow the traditional rules for capital gains and losses. First, short-term capital gains and losses (including carryovers) are netted. Next, long-term capital gains and losses (including carryovers) are netted. Finally, the net short-term gain or loss is combined with the net long-term gain or loss.
