Finance:Exchange fund

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An exchange fund, also known as a swap fund, is an investment vehicle that allows investors with large stock positions to pool their stocks into a single fund, diversifying their holdings without triggering a taxable event. Given its dependence on the IRS Tax Code, it is a mechanism specific to the United States , first introduced as early as 1954 with the passage of 26 U.S. Code § 721[1] though the practice traces back to the 1930s through other tax provisions. The primary benefit of this arrangement is to diversify a large stock position without triggering a "taxable event". Note that the tax is not avoided, just deferred. Deferring taxes avoids tax drag, as the money lost to taxes remains invested in the market, letting the portfolio compound from a larger base. When the diversified holdings are eventually sold, tax will be due on the difference between the sales price and the original cost basis of the contributed stock.

Detailed structure and eligibility

  • Exchange fund participants are typically qualified purchasers[2] with at least $5 million in investible assets. Investment minimums run from $500,000 to $1 million at firms like Eaton Vance and Goldman Sachs.[3] Newer entrants like Cache are making them available to accredited investors with investment minimums of $100,000.[4]
  • Fund holding requirements: A fund needs to hold at least 20% in qualifying illiquid assets like real estate or commodities.
  • Liquidity: An additional tax benefit of being able to withdraw a diversified portfolio without a taxable event opens up at seven years. Redemptions before seven years can only be met with stocks contributed by the investor, and might be subject to penalties.

Benefits and drawbacks

  • Exchange funds diversify an investor's concentrated position, reducing concentration risk.
  • Exchange funds reduces tax drag[5] since the entire principal is invested in the diversified portfolio, rather than a smaller post-tax base. A larger asset base should theoretically compound faster.
  • Exchange funds help investors overcome several biases that can discourage them from diversifying a concentrated position (such as the anchoring bias that occurs when a stock loses value).
  • Exchange require a long-term investment (of at least seven years).
  • Risks associated with exchange funds include liquidity risks, investment risks, tax law risks, leverage risks, and others.

Providers

Historically, exchange funds have been offered primarily by two major investment firms, specifically for their ultra-wealthy clients. Morgan Stanley (through Eaton Vance) is a prominent provider of these funds. Goldman Sachs[6] offers exchange funds as well. Newer entrants like Cache[7] offer exchange funds that are more accessible to a broader range of investors.

Regulatory and Policy Questions

Exchange funds became popular after Eaton Vance obtained a private ruling from the IRS in 1975 allowing their use. [8] The U.S. Securities and Exchange Commission has investigated the use of these arrangements with reference to the potential for market abuse by directors not disclosing their effective divestment in stocks for which they are privy to sensitive market information.[9]

In addition, there is general public policy disagreement whether tax revenue that is generated from exchange funds and other like-kind exchanges should be deferred or avoided. [10] Many holders of appreciated positions may elect to hold the concentrated position and borrow against it rather than sell and pay the associated capital gains tax, which results in deadweight loss to the economy. Proponents argue that exchange funds help with this significant deadweight loss as holders of appreciated stock can diversify and liquidate their positions, re-injecting this capital into the economy. Opponents argue that exchange funds serve just a narrow slice of the population. For example, public figures like politician Mitt Romney[11] and businessman Eli Broad[12] have been identified as using exchange funds to reduce their tax obligations. Regulatory filings indicate that it is a frequently used strategy by high-ranking corporate executives.

Public vs. private equity exchange funds

Private equity exchange funds (those comprising stock in non-public companies) differ from public exchange funds in a few regards:

  • A main objective of private equity exchange funds is providing participants with downside risk protection, in case their own stock becomes worthless before they achieve a liquidity event (an IPO or acquisition.) The need for diversification can be higher than it is with public stock which may be sold at any time, if the holder wishes to bear the tax consequences.
  • When liquidity events occur within a private equity fund, proceeds are immediately distributed to limited partners, rather than being held or reinvested. The objective of these funds is liquidity as well as diversification.
  • Public funds are generally not marginable. Private funds may increase a participant's odds of liquidity.[13][better source needed]
  • Fund management fees are assessed on the basis of an expense budget, rather than a percent of the value, since valuation of the private equity holdings is uncertain.
  • Liquidity: For public exchange funds, at least seven years must elapse between when an investor deposits their stock and when the basket of stocks is available for them to sell without realizing a step up in basis (paying taxes). However, this is not an issue with private stock exchange funds as the point is diversification, not tax deferral.

References

  1. ↑ John A., DiCiccio. "Exchange Funds: The Tax Consequences of a Transfer of Appreciated Stock to a Partnership or a Mutual Fund". https://www.djcl.org/wp-content/uploads/2014/07/EXCHANGE-FUNDS-THE-TAX-CONSEQUENCES-OF-A-TRANSFER-OF-APPRECIATED-STOCK-TO-A-PARTNERSHIP-OR-A-MUTUAL-FUND1.pdf. 
  2. ↑ "Defining the term "Qualified Purchaser". https://www.sec.gov/rules/2001/12/defining-term-qualified-purchaser-under-securities-act-1933. 
  3. ↑ Hube, Karen (June 17, 2019). "The Tax Benefits of Exchange Funds". https://www.barrons.com/articles/the-tax-benefits-of-exchange-funds-51560794410. 
  4. ↑ Narayan, Srikanth. "What's an Exchange Fund? Pros and Cons for Investors". https://usecache.com/companion/what-is-an-exchange-fund#toc-3. 
  5. ↑ "Tag Drag: What It Means, How It Works"". https://www.investopedia.com/terms/t/tax-drag.asp. 
  6. ↑ "Goldman Sachs Exchange Funds". https://qa.gsam.com/content/gsam/us/en/advisors/tools/exchange-place-jp.html. 
  7. ↑ "Modern Exchange Funds for your large stock positions". https://usecache.com/product/exchange-funds. 
  8. ↑ The Tax Consequences of a transfer of appreciated stock to a partnership or mutual fund
  9. ↑ www.alwayson-network.com/
  10. ↑ Herzig, David (February 2, 2010). "Am I the Only Person Paying Taxes?: The Largest Tax Loophole for the Rich". Valparaiso University Law School Legal Studies Research Paper Series (Valparaiso University Legal Studies Research Paper No. 10-01). https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1548669. 
  11. ↑ Confessore, Nicholas (January 27, 2012). "Goldman Sachs Ties Enrich Romney". NBC News. https://www.nbcnews.com/id/wbna46172017. 
  12. ↑ Henriques, Diana B. (December 1, 1996). "Wealthy, Helped by Wall St., New Find Ways to Escape Tax on Profits". New York Times. https://www.nytimes.com/1996/12/01/business/wealthy-helped-by-wall-st-new-find-ways-to-escape-tax-on-profits.html. 
  13. ↑ www.answers.com



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