Exchange funds are stock funds that allow individual investors to exchange their ownership of an individual stock for units in the exchange fund at a mutually agreed rate of exchange. The swap nature of the transaction means that exchange funds are also known as swap funds. They allow individual investors to increase their investment diversification in a tax efficient manner since the capital gains tax liability of the individual investor is effectively deferred.
Reflecting their primary purpose, exchange funds are commonly marketed to investors as a solution to concentrated wealth. They are sometimes mistakenly confused with exchange traded funds; but the two products are quite different investment vehicles. One major point of difference is that exchange funds are not listed on an official exchange and hence cannot be publicly traded.
The stock swapped into an exchange fund is not a sale for tax purposes, and therefore it is not a taxable event. This allows the investor to defer payment of any capital gains tax until that investor sells the units in the exchange fund. At that point, tax will be payable by the investor on the difference between the sale price of the units and the original cost of the shares that were swapped into the exchange fund.
Exchange funds are unique to the United States. They have existed for almost 50 years, but grew significantly in number and value during the late 1990s. This was the end of the technology boom, when many individuals amassed significant stock in a single or limited number of technology companies.
Exchange funds may be either private or public. Private exchange funds own private, unlisted companies, while public exchange funds own publicly traded shares. There are a number of large operators who provide one or the other type of fund. In addition, there are numerous small exchange funds formed by several individuals, each of whom have the same issue in the form of wealth concentrated in one, or a few, major stocks. They collectively form a limited partnership, swapping some of their stock into the fund in return for units in the fund.
Exchange funds may also allow individuals to lighten their holding of an individual stock without breaching lock-up restrictions. This is because stocks held by an exchange fund are unlikely to be sold before seven years. To minimize it capital gains tax liability, an exchange fund must retain ownership of its stocks for at least seven years.
