Chino Yuichiro | Instant | Getty Images
For leaders and founders who got rich from a single action, sometimes it’s possible to have too much of a good thing.
Although the boom in tech stocks represents a boon for employees of high-flying companies, it’s risky to concentrate too much of your net worth in a single stock. Some advisors follow a 10% rule of thumb, meaning no stock or asset should make up more than 10% of a portfolio.
“This represents both the biggest risk and the biggest opportunity for this client,” said Rob Romano, head of capital markets investor solutions at Merrill.
Founders and long-time employees who want to diversify their portfolios may face high capital gains taxes when they sell long-held shares in order to reinvest them. Instead, they can contribute their shares to an exchange fund (not to be confused with ETFs).
Exchange funds, also called exchange funds, pool the shares of several investors, who receive a partnership interest or share in the fund. After a designated lock-up period – typically seven years – investors can redeem their shares for a diversified basket of shares equal to their stake in the fund.
While exchange funds became common in the 1970s, they have gained popularity in recent times as the stock market posts strong returns, driven in part by the rise of artificial intelligence.
Eric Freedman, chief investment officer of Northern Trust’s wealth management business, said many publicly traded technology companies are increasing their equity compensation to compete with hot AI startups for talent.
Exchange funds typically hold 80% of their assets in stocks and aim to reflect benchmarks like the S&P500 or Russell 3000. The Internal Revenue Service requires that the remaining 20% be held in non-security assets, with real estate being the most popular option.
Steve Edwards, senior investment strategist for Morgan Stanley’s wealth management division, said he sees clients increasingly using exchange funds as a wealth transfer strategy.
“What exchange funds help us do is narrow the range of outcomes, because a single stock will have a very wide range of outcomes,” he said. “Imagine you’re 70 years old and you have an incredible amount of inventory, but then it turns into a dumpster fire and, essentially, you can’t pass on to your heirs the inheritance you were hoping for.”
Still, getting customers to hedge their bets is often a difficult proposition, Edwards said.
“People remember the blessing that the stock has been to them and their families, and they extrapolate that that blessing will continue,” he said. “What we found in our research and work is that stocks that have outperformed actually tend to underperform more in the future.”
Customers typically contribute only a portion of their shares to an exchange fund to cash out a few tokens, he said.
Exchange funds only accept accredited investors worth more than $1 million or who have earned more than $200,000 in the last two calendar years.
And the lock-up period comes with fine print: If an investor redeems before seven years, they lose the tax benefit and may have to pay high fees. Instead of receiving a diversified basket of shares, the investor typically gets their original shares back, equal to the value of their stake in the fund.
Scott Welch, chief investment officer of multi-family office Certuity, said he recommends against exchange funds because of the lock-up period. There are more flexible ways to reduce risk, such as collars, prepaid variable futures or tax-loss harvesting with long and short positions, he said. If liquidity is the client’s primary goal, borrowing against stocks is another solid option.