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Exchange Funds: How They Work, Pros and Cons
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Exchange Funds: How They Work, Pros and Cons
An exchange fund is an option to lower the risk of a concentrated stock, but there are caveats to keep in mind.
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Erica Corbin is a former assigning editor at NerdWallet. Erica joined NerdWallet in 2020 as an assistant assigning editor at large. In 2023, she was promoted to assigning editor and helped lead the credit cards vertical at NerdWallet Canada. She previously wrote and edited content at companies such as GOBankingRates and Nasdaq. Her work has been syndicated to USA Today, Yahoo Finance, MSN and more.
Erica Corbin is a former assigning editor at NerdWallet. Erica joined NerdWallet in 2020 as an assistant assigning editor at large. In 2023, she was promoted to assigning editor and helped lead the credit cards vertical at NerdWallet Canada. She previously wrote and edited content at companies such as GOBankingRates and Nasdaq. Her work has been syndicated to USA Today, Yahoo Finance, MSN and more. Assigning Editor + more + moreEmployee equity is a valuable financial benefit, but it can also introduce a new risk to your financial health: If you own a lot of stock in the company where you work, you're hitching the bulk of your financial well-being to that wagon.
Employee equity is a valuable financial benefit, but it can also introduce a new risk to your financial health: If you own a lot of stock in the company where you work, you're hitching the bulk of your financial well-being to that wagon.That's because not only is your income dependent on that company's success, but your investment portfolio may be, too. That's especially true if you hold what's called a concentrated stock position: A significant portion of your investment portfolio is in just a handful of stocks. In the case of company stock, this is not at all uncommon.
That's because not only is your income income dependent on that company's success, but your investment portfolio may be, too. That's especially true if you hold what's called a concentrated stock position: A significant portion of your investment portfolio is in just a handful of stocks. In the case of company stock, this is not at all uncommon.Enter exchange funds
Enter exchange fundsAn exchange fund is an investment vehicle that pools the concentrated stock positions of many investors, creating a diversified collection of stocks. Investors swap their concentrated positions — for example, holdings of their own company stock — for a partnership interest or share of the exchange fund.
An exchange fund is an investment vehicle that pools the concentrated stock positions of many investors, creating a diversified collection of stocks. Investors swap their concentrated positions — for example, holdings of their own company stock — for a partnership interest or share of the exchange fund. 🤓 Nerdy TipAn exchange fund is not the same thing as an exchange-traded fund (ETF). An ETF is also a pooled investment fund, but ETFs are publicly traded like a stock and are generally open to any investor. An exchange fund is a private fund.
An exchange fund is not the same thing as an exchange-traded fund (ETF) . An ETF is also a pooled investment fund, but ETFs are publicly traded like a stock and are generally open to any investor. An exchange fund is a private fund.This swap allows investors to substitute or replace a concentrated stock position with a diversified basket of stocks of the same value, potentially reducing portfolio risk and deferring some tax consequences until later.
This swap allows investors to substitute or replace a concentrated stock position with a diversified basket of stocks of the same value, potentially reducing portfolio risk and deferring some tax consequences until later.Typically, investors must hold their shares of exchange funds for seven years before they have the option to redeem the shares. Generally, the shares in the exchange fund are then redeemed for shares of the stocks held in the portfolio
Typically, investors must hold their shares of exchange funds for seven years before they have the option to redeem the shares. Generally, the shares in the exchange fund are then redeemed for shares of the stocks held in the portfolio Financial Planning Association. Tax-Efficient Ways to Diversify Concentrated Stock Positions. Accessed Jun 26, 2026. . AdvertisementGet matched to a financial advisor for free with NerdWallet Advisors Match.
Exchange funds typically reinvest the capital gains and dividends instead of distributing that cash to investors. But a taxable event occurs when you redeem your shares of the exchange fund. Your cost basis is the cost basis of the stock you handed over (the amount you paid to originally purchase the stock).
Exchange funds typically reinvest the capital gains and dividends instead of distributing that cash to investors. But a taxable event occurs when you redeem your shares of the exchange fund. Your cost basis cost basis is the cost basis of the stock you handed over (the amount you paid to originally purchase the stock).» MORE: Other strategies to reduce capital gains tax
» MORE: » MORE: Other strategies to reduce capital gains tax Other strategies to reduce capital gains taxWhat is the strategy behind investing in exchange funds?
What is the strategy behind investing in exchange funds?When diversifying your investment portfolio, the baseball strategy of swinging for singles and doubles instead of home runs comes to mind. Having too much exposure by way of a concentrated position — the equivalent of banking on home runs to win — can increase the risk of your overall portfolio.
When diversifying your investment portfolio, the baseball strategy of swinging for singles and doubles instead of home runs comes to mind. Having too much exposure by way of a concentrated position — the equivalent of banking on home runs to win — can increase the risk of your overall portfolio.But you don't have to have just one stock in your portfolio to introduce risk — usually, once a single stock position reaches 10% or more of your portfolio, risk begins to intensify. Using an exchange fund can be one way to reduce your risk, providing protection in case a significant part of your investment portfolio ends up performing poorly.
But you don't have to have just one stock in your portfolio to introduce risk — usually, once a single stock position reaches 10% or more of your portfolio, risk begins to intensify. Using an exchange fund can be one way to reduce your risk, providing protection in case a significant part of your investment portfolio ends up performing poorly.Exchange funds are frequently used by company executives, who often end up heavily invested in their employers’ stock. Some companies even require senior managers to own a certain percentage of the company in order to align their personal interests with those of the company. But as noted above, any worker with employee equity can become concentrated in their company’s stock through stock options or RSUs.
Exchange funds are frequently used by company executives, who often end up heavily invested in their employers’ stock. Some companies even require senior managers to own a certain percentage of the company in order to align their personal interests with those of the company. But as noted above, any worker with employee equity can become concentrated in their company’s stock through stock options stock options or RSUs RSUs .Exchange funds aren't just for employee equity
Exchange funds aren't just for employee equityExchange funds and concentrated positions are often aligned with equity compensation, but the reality is that a lot of people end up with concentrated stock positions. For example:
Exchange funds and concentrated positions are often aligned with equity compensation, but the reality is that a lot of people end up with concentrated stock positions. For example:Regular investors may end up with concentrated stock positions if one stock in their portfolio has significantly outperformed others over time and now represents a disproportionate share of the portfolio.
Regular investors may end up with concentrated stock positions if one stock in their portfolio has significantly outperformed others over time and now represents a disproportionate share of the portfolio.People who have inherited a family business or other long-time investment may have concentrated stock positions.
People who have inherited a family business or other long-time investment may have concentrated stock positions.Instead of having to sell shares to diversify your portfolio and pay the associated capital gains taxes, which can be hefty, an exchange fund could be a potential solution.
Instead of having to sell shares to diversify your portfolio and pay the associated capital gains taxes capital gains taxes , which can be hefty, an exchange fund could be a potential solution.Pros and cons of exchange funds
Pros and cons of exchange funds ProsHelps diversify your portfolio.
Can help defer capital gains taxes.
ConsYou must be an accredited investor.
The minimum investment is high.
The disclosure rules are different.
Long-term investment.
Fund might not make money.
Fees may be different.
More about these pros
More about these pros DiversificationThe main reason to use an exchange fund is diversification. Spreading your investment dollars across a wide range of assets can help you reduce volatility and investment risk, so that no one asset has an outsize impact on the performance of your overall investment portfolio. An exchange fund helps you replace a concentrated position with a diversified one.
The main reason to use an exchange fund is diversification diversification . Spreading your investment dollars across a wide range of assets can help you reduce volatility and investment risk, so that no one asset has an outsize impact on the performance of your overall investment portfolio. An exchange fund helps you replace a concentrated position with a diversified one. Tax deferralSome concentrated stock positions can become sizable due to the stock’s appreciation over time. This means the stock has accumulated large capital gains, and selling shares to diversify may generate a significant capital gains tax bill. Depending on your tax situation, it may make financial sense to delay those capital gains taxes or even to bequeath your exchange fund shares to heirs. The heirs may benefit from a step-up in cost basis (meaning the cost basis of the asset is the fair market value of the asset on the day they inherit it).
Some concentrated stock positions can become sizable due to the stock’s appreciation over time. This means the stock has accumulated large capital gains, and selling shares to diversify may generate a significant capital gains tax bill. Depending on your tax situation, it may make financial sense to delay those capital gains taxes or even to bequeath your exchange fund shares to heirs. The heirs may benefit from a step-up in cost basis (meaning the cost basis of the asset is the fair market value of the asset on the day they inherit it).» Compare top-rated wealth management firms for high-net-worth investors
» Compare top-rated wealth management firms for high-net-worth investors » Compare top-rated wealth management firms for high-net-worth investorsMore about these cons
More about these cons Limited to accredited investorsTypically, exchange funds are structured as private placement limited partnerships, or limited liability companies, which means that only accredited investors with over $1 million in net worth or annual income over $200,000 can participate
Typically, exchange funds are structured as private placement limited partnerships, or limited liability companies, which means that only accredited investors with over $1 million in net worth or annual income over $200,000 can participate NAEPC Journal of Estate & Tax Planning. Planning Ideas—Exchange Funds . Accessed Jun 29, 2026. . High minimumsExchange funds usually have high minimum investment requirements, often hundreds of thousands of dollars (or more) worth of shares in the stock being exchanged.
Exchange funds usually have high minimum investment requirements, often hundreds of thousands of dollars (or more) worth of shares in the stock being exchanged. Less disclosureExchange funds are not registered securities, so they aren’t subject to some of the Securities and Exchange Commission requirements for information disclosure that other securities are.
Exchange funds are not registered securities, so they aren’t subject to some of the Securities and Exchange Commission requirements for information disclosure that other securities are. LiquidityExchange funds usually require investors to hold their partnership shares for at least seven years before redemption (which involves completing the swap of your concentrated position into a basket of stocks) without penalty
Exchange funds usually require investors to hold their partnership shares for at least seven years before redemption (which involves completing the swap of your concentrated position into a basket of stocks) without penalty Cornell Law School Legal Information Institute. 26 U.S. Code § 704 - Partner’s distributive share. Accessed Aug 18, 2025. . Seven years is a long time to wait and could present an issue if your financial circumstances change and you need access to your investments during that time. Redeeming partnership shares early could mean a return of your concentrated stock rather than shares of the diversified fund you were seeking. Qualifying assetsExchange funds give you the ability to swap your stock for the fund’s partnership shares tax-free. To maintain eligibility for this preferential tax treatment, exchange funds are required to keep a 20% minimum of total gross assets in certain qualifying investments to help minimize portfolio volatility
Exchange funds give you the ability to swap your stock for the fund’s partnership shares tax-free. To maintain eligibility for this preferential tax treatment, exchange funds are required to keep a 20% minimum of total gross assets in certain qualifying investments to help minimize portfolio volatility Morgan Stanley. Exchange Funds An Important Alternative for Your Asset Allocation. Accessed Jun 29, 2026. . Often, these qualifying investments might be commodities or real estate, which can potentially be riskier and less liquid than traditional stock holdings. FeesWith any investment, your costs matter. Exchange funds may charge an upfront sales charge as well as ongoing investment management fees.
With any investment, your costs matter. Exchange funds may charge an upfront sales charge as well as ongoing investment management fees. Advertisement1
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Is an exchange fund right for you?There are different ways to handle concentrated stock positions, and exchange funds are one. Although exchange funds can help you diversify away from the investment risk of a single stock position, you’ll still encounter the ups and downs of stock market fluctuations. Your diversified partnership shares could perform better, or worse, than what your single stock position might have done. Seeking the advice of a financial advisor or wealth advisor can help you weigh your options and decide if using an exchange fund may be an advantageous strategy for your financial situation.
There are different ways to handle concentrated stock positions, and exchange funds are one. Although exchange funds can help you diversify away from the investment risk of a single stock position, you’ll still encounter the ups and downs of stock market fluctuations. Your diversified partnership shares could perform better, or worse, than what your single stock position might have done. Seeking the advice of a financial advisor or wealth advisor can help you weigh your options and decide if using an exchange fund may be an advantageous strategy for your financial situation.» See our list of the best financial advisors
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Enter exchange funds Enter exchange funds What is the strategy behind investing in exchange funds? What is the strategy behind investing in exchange funds? Exchange funds aren't just for employee equity Exchange funds aren't just for employee equity Pros and cons of exchange funds Pros and cons of exchange funds Is an exchange fund right for you? Is an exchange fund right for you?ON THIS PAGE
Enter exchange funds Enter exchange funds What is the strategy behind investing in exchange funds? What is the strategy behind investing in exchange funds? Exchange funds aren't just for employee equity Exchange funds aren't just for employee equity Pros and cons of exchange funds Pros and cons of exchange funds Is an exchange fund right for you? Is an exchange fund right for you? More like this Investing How Much Does a Financial Advisor Cost? Most financial advisors charge based on how much money they manage for you, but the industry average is around 1% of your asset balance per year. Arielle O'Shea Do You Need a Financial Advisor? 7 Ways to Tell You may need a financial advisor if you're facing big life changes, don't have financial goals, have complex compensation, high tax bills or for other reasons. Taryn Phaneuf How to Find Cheap or Free Financial Advice Quality financial advice is more accessible than ever — and much of it is free or inexpensive. Here's how to get it. June Sham 3 Steps to Prepare for Your First Financial Advisor Meeting Here's what think about and bring to your first meeting with a financial advisor. June ShamGet matched to a financial advisor for free with NerdWallet Advisors Match.
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