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.
Do I pay capital gains if I 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 like income from the underlying stocks or bonds they hold. For U.S. taxpayers, this income needs to be reported on form 1099-DIV. 18 If you profit by selling shares in an ETF, that is taxed, like when you sell stocks or bonds.
What are the advantages and disadvantages of exchange traded funds? ›
Advantages and Disadvantages of ETFs
We can now discuss not just what ETFs are but their specific advantages and disadvantages. Tax efficiency and liquidity are seen as advantages, popular disadvantages are potentially lower returns and higher costs.
What is the benefit of choosing an exchange traded fund? ›
ETFs can offer lower operating costs than traditional open-end funds, flexible trading, greater transparency, and better tax efficiency in taxable accounts. For nearly a century, traditional mutual funds have offered many advantages over building a portfolio one security at a time.
What is the downside of exchange funds? ›
There are numerous fees and expenses associated with an exchange fund, including but not limited to those associated with advisory, distribution, shareholder servicing, redemption, selling commissions, interest, and borrowing costs. Tax risks.
Is it better to pay capital gains or do a 1031 exchange? ›
The main benefit of carrying out a 1031 exchange rather than simply selling one property and buying another is the tax deferral. A 1031 exchange allows you to defer capital gains tax, thus freeing more capital for investment in the replacement property.
How do I avoid capital gains tax on ETFs? ›
Through everyday redemptions and heartbeat trades, equity ETFs are able to make tax-free portfolio adjustments and avoid generating capital gains until their shareholders sell their shares.
How much is capital gains tax on ETFs? ›
For ETFs held more than a year, you'll owe long-term capital gains taxes at a rate up to 23.8%, once you include the 3.8% Net Investment Income Tax (NIIT) on high earners.
How to avoid capital gains tax? ›
9 Ways to Avoid Capital Gains Taxes on Stocks
- Invest for the Long Term. ...
- Contribute to Your Retirement Accounts. ...
- Pick Your Cost Basis. ...
- Lower Your Tax Bracket. ...
- Harvest Losses to Offset Gains. ...
- Move to a Tax-Friendly State. ...
- Donate Stock to Charity. ...
- Invest in an Opportunity Zone.
As an investor, they allow you to diversify your holdings without selling stock and triggering a taxable event. Exchange funds are not new; they've been used to reduce concentration risk tax-efficiently since the 1930s.
What is the difference between an ETF and an exchange-traded fund? ›
Exchange-traded funds (ETFs) trade on stock exchanges throughout the day, while mutual funds are bought or sold at the net asset value (NAV) at the end of the trading day, and ETFs often have lower expense ratios than mutual funds.
Why is ETF not a good investment? ›
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.
How do exchange-traded funds make money? ›
Most ETF income is generated by the fund's underlying holdings. Typically, that means dividends from stocks or interest (coupons) from bonds. Dividends: These are a portion of the company's earnings paid out in cash or shares to stockholders on a per-share basis, sometimes to attract investors to buy the stock.
Why is ETF tax efficient? ›
Primary market creation and redemption transactions are typically conducted in-kind, meaning securities are exchanged for ETF shares, rather than for cash. These in-kind transactions do not trigger a taxable event for the fund, helping to improve the tax efficiency of ETFs.
What is an exchange-traded fund for dummies? ›
Key Takeaways. An exchange-traded fund (ETF) is a basket of securities that trades on an exchange just like a stock does. ETF share prices fluctuate all day as the ETF is bought and sold; this is different from mutual funds, which only trade once a day after the market closes.
Do I pay capital gains tax if I reinvest the money? ›
Do I Pay Capital Gains if I Reinvest the Proceeds From the Sale? While you'll still be obligated to pay capital gains after reinvesting proceeds from a sale, you can defer them. Reinvesting in a similar real estate investment property defers your earnings as well as your tax liabilities.
Is switching funds capital gains tax? ›
If you switch from an equity fund before one year, you will have to pay short-term capital gains tax at 20%. If you switch after one year, you will have to pay long-term capital gains tax at 12.5% on the gains exceeding Rs. 1.25 lakh in a financial year.
Is foreign exchange gain a capital gain? ›
For most investors, foreign exchange gains and losses will likely be considered to be capital in nature.
Can you exchange stocks without paying capital gains? ›
You and other investors who want to avoid paying tax on stocks that have appreciated, will “sell” (in actuality contribute) and reinvest, through a swap. This process involves swapping your appreciated shares for a diversified portfolio of stocks of equivalent value, effectively deferring capital gains tax.
