The Investment Scientist

Top Ten Reasons To Avoid Exchange Funds

Posted on: July 13, 2018

Tojas_eltort.jpgA few days ago, I was approached by an employee of Nvidia regarding his $5mm worth of NVDA stock. A Morgan Stanley broker had pitched him the idea of using exchange funds to diversify his holdings and he wanted my second opinion.

If you are an employee of any of those high flying tech companies like Amazon, Facebook, Google, Apple, Microsoft, Netflix, and etc., you are likely to have been pitched such an idea. Talk to me before you execute anything.

So what exactly are exchange funds? Exchange funds are unregistered private-placement limited partnerships or LLCs designed specially for investors with concentrated positions in highly appreciated stocks to help them diversify without triggering taxes.

How do they work? Investors transfer shares of their concentrated stocks to the fund in exchange for an equal value of units of the fund. These transfers are not taxable since they are considered partnership capital contributions under the tax law. There are a few caveats to the law though: investors have to stay in the fund for a minimum of seven years and the fund must invest 20% of its capital in illiquid assets.

What are the pros of exchange funds? They are a legitimate way to defer taxes and they are certainly more diversified than holding on to one concentrated stock.

What are the cons of exchange funds? Gosh, there are many – where do I start?

  1. They simply defer (not eliminate) your taxes. It’s like paying someone to kick your can down the road.
  2. They are not very diversified since they are formed by volunteer contributions of highly appreciated stocks.
  3. They are expensive to participate in. There is typically a 1% to 2% front load, and ongoing expenses of 1% a year.
  4. You can’t take your money out for seven years.
  5. These funds are unregistered private placement investment vehicles outside of SEC oversight. You have no idea what’s going on within them and whether any of their reporting is true. This is called asymmetric information risk by the way. The parties who have more information ( fund originators and managers) are prone to take advantage of the parties who have less information (fund investors.)
  6. There is the 20% illiquid asset requirement, and you have no control if the managers play with it to benefit themselves. This is called agency risk (or moral hazard.) The parties who are in control are prone to take advantage of the parties who are not.
  7. You never know what you’ll get when you redeem the fund, since instead of money, the fund will give you shares of stocks in the fund as well as the illiquid assets that collectively have the same basis as the stocks you originally transferred.
  8. The fund is a record-keeping hell. The convenient thing about being unregistered and unregulated is that if the fund managers mess up, they don’t have to tell you so you can remain  blissfully unaware.
  9. You have to pay taxes too when the managers sell other people’s highly appreciated stocks in the fund.
  10. It’s a tax filing hell for you because after redemption you will end up with a bunch of unfamiliar stocks and illiquid assets with unknown basis (since you did not buy them yourself.)

I shared the above ten cons with the Nvidia employee and he was very glad since the broker did not tell him any of these. That’s the one last point I want to make. 99% of financial “advisers” in this country are brokers who are not legally required to put your interests first. Their job is to make transactions happen so they can collect fees and commissions from both sides. No matter what idea you’ve been pitched by a broker or an insurance agent, get a second opinion from a fiduciary like myself.

(Feel free to share if you find it insightful.)

Schedule a 2nd opinion financial review, buy my wealth mgmt bookon Amazon.

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Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.


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