For many executives and founders who have prospered from massive gains in a single stock, the adage that one can have too much of a good thing is becoming increasingly relevant. The tech stock boom has ushered in significant financial rewards, particularly for employees at successful tech companies. However, financial advisors caution against the risks of having too much of an individual’s net worth concentrated in one stock. The so-called “10% rule” suggests that no single stock or asset should constitute more than 10% of an investor’s portfolio.
Rob Romano, head of capital markets investor solutions at Merrill, emphasizes the dual nature of this situation. “It represents both the biggest risk and biggest opportunity for that client,” he noted. Many founders and long-term employees aware of the potential pitfalls are looking for ways to diversify their portfolios but face hefty capital gains taxes when selling long-held stock. One method to navigate these challenges is through the use of exchange funds, which should not be confused with exchange-traded funds (ETFs).
Exchange funds, commonly known as swap funds, pool shares from multiple investors, granting participants a partnership interest based on their contributions. After a specified lock-up period, typically lasting seven years, investors can redeem their interest for a diversified selection of stocks. Although these funds became mainstream in the 1970s, their popularity has surged recently, particularly in light of strong market performances bolstered by advancements in artificial intelligence. Eric Freedman, chief investment officer of Northern Trust’s wealth management division, notes that many publicly traded tech companies are increasing their equity compensation to attract talent in the booming AI sector.
Typically, exchange funds allocate about 80% of their assets to stock holdings, striving to replicate benchmark indexes such as the S&P 500 or Russell 3000. The remaining 20% is mandated by the Internal Revenue Service to consist of non-security assets, with real estate emerging as a commonly chosen option.
Steve Edwards, senior investment strategist for Morgan Stanley’s wealth division, has observed that clients are increasingly leveraging exchange funds as a strategy for wealth transfer. “What exchange funds are helping us to do is to narrow the range of outcomes because a single stock will have a very wide range of outcomes,” he explained. Yet, persuading clients to reduce their dependence on a single stock can be a daunting task. “People remember the blessing the stock has been to them and their family, and they’re extrapolating forward that the blessing will continue,” he added, citing research that shows stocks that have previously outperformed are likely to underperform in the future.
It’s important to note that clients often contribute only a fraction of their shares to exchange funds, allowing them to take some risks off the table. Additionally, these funds are restricted to accredited investors—individuals with a net worth exceeding $1 million or with an annual income exceeding $200,000 for the previous two calendar years. The lock-up period carries stipulations: if an investor opts to redeem their shares before the seven-year mark, they forfeit tax benefits and could face significant fees. In such cases, they might receive their original shares instead of a diversified basket.
Despite the advantages, there are voices in the financial community expressing caution about exchange funds. Scott Welch, chief investment officer at multi-family office Certuity, advises against using them primarily due to their lock-up feature. He points to alternative strategies for risk de-escalation, including options such as collars and variable prepaid forwards or employing tax-loss harvesting strategies with long and short positions. For those focused on liquidity, borrowing against the stock may present a more flexible solution. The ongoing dialogue around exchange funds highlights the complexities and considerations high-net-worth individuals must navigate when managing their wealth.
