Exchange Fund

An exchange fund (also known as a "swap fund") is a stock fund that allows an investor to exchange his or her large holding of a single stock for units in a portfolio. Exchange funds provide investors with an easy way to diversify their holdings while deferring any taxes from capital gains.

Because an investor swaps shares with the fund, no sale actually occurs. This allows the investor to defer the payment of capital gains tax until he or she sells the fund's units.

There are both private and public exchange funds. The former deals with companies that are not publicly traded, providing investors with a way to diversify private equity holdings. The public funds offer investors portfolio shares containing publicly traded firms.

Exchange funds are designed to appeal primarily to investors who previously focused on building concentrated positions on restricted or highly appreciated stock, but who are now looking to diversify. Typically, a large bank, an investment company, or other financial institution will create a fund that will have a certain size and blend it is targeting for in terms of the stock that is contributed.

Participants in an exchange fund will contribute some of the shares they hold, which are then pooled with other investors’ shares. With each shareholder that contributes, the portfolio becomes increasingly diversified. An exchange fund may be marketed toward executives and business owners, who have amassed positions that typically are centered on one or a handful of companies. Participating in the fund allows them to diversify those heavily concentrated positions on stocks.

Exchanged funds may require the potential participants to have a minimum liquidity of $5 million cash in order to join and contribute.

As the fund grows, and when enough shares have been contributed, the fund closes to new shares. Then each investor is given interest in the collective shares based on their portion from the original contributions. The shares in the fund moved to the exchange fund are not immediately subject to capital gains taxation.

If an investor decides they wish to leave an exchange fund, they will receive shares drawn from the fund rather than cash. Those shares will be dependent on what has been contributed to the fund and is still available. Up to 80 percent of the assets in an exchange fund can be stocks, but the rest must be made up of illiquid investments, such as real estate investments.