Chicken McNuggets. You wouldn’t think they have an awful lot to do with diversifying your investment portfolio, but after this anecdote, you might think otherwise. After McDonald’s invented the Chicken McNugget, the company approached famous hedge fund manager Ray Dalio for help in hedging against chicken prices. According to him, “They came to me and said, ‘Look, we have all of this exposure. How do we protect ourselves so we don’t have to change the menu price of Chicken McNuggets all the time?’ I helped them through that.”
The concentrated stock held in your investment portfolio is akin to the Chicken McNuggets on the McDonald’s menu. McDonald’s had the foresight to know that holding so much of its capital in chicken could prove volatile—even disastrous—in the future if it owned chicken it couldn’t sell. The same volatility could be true for your concentrated stock positions. However, there are investment options that can help you diversify your investment portfolio. Here’s a closer look at one option—how to use exchange funds for concentrated positions.
What Is an Exchange Fund?
An exchange fund is a fund structured to accept large concentrated stock positions from multiple sources in exchange for ownership shares of the fund, instantly giving the investor a more diversified position. Use of an exchange fund is a unique strategy that many advisors and executives alike are not familiar with. However, when utilized correctly, it can be a great method to help diversify concentrated stock positions.
The main advantage of an exchange fund is made possible through tax laws that allow the transfer of a concentrated stock position (or another asset) with a low income tax basis into a larger portfolio of more diversified assets. The capital gains tax on your low-basis asset is deferred until the assets within the diversified fund are sold, making it a tax-deferred transition into the exchange fund.
As an example, let’s say that we have an executive client named Joe. Joe initially pays $100,000 for stock, which continues to grow tax deferred and is now worth $1 million. He wants to diversify his stock position, but he doesn’t want to pay tax on the growth—the $900,000. The unique strategy of utilizing an exchange fund would allow Joe to trade his $1 million of company stock, and the exchange fund would take in that $1 million of stock as one of the holdings in its fund.
In exchange for Joe’s stock position, he would be given a number of shares of the fund commensurate with the dollar amount of stock that he contributed—in this case, $1 million. His shares of the exchange fund would be comprised of a diversified amount of stocks, effectively diversifying his concentrated stock position while deferring his capital gains taxation. The fund itself would be comprised of stocks from other individuals’ concentrated positions, which were given in exchange for shares of the exchange fund.
Using Exchange Funds for Concentrated Positions
As a top-level executive, you likely have accumulated a concentrated stock position in one or more stocks through employee stock options or other forms of equity compensation.
You know that a concentrated stock position comes with great upside potential if the company continues to grow at a faster pace than other companies listed on the stock exchange. However, you likely also know in the back of your mind that this concentrated position comes with a tremendous amount of risk. “Putting all of your eggs in one basket,” as the saying goes, is not a great long-term strategy if you are looking to avoid large risk exposure concerning your personal investment assets.
If you are looking to diversify a concentrated stock position, an exchange fund is an extremely beneficial tool to consider. To do this, you would work with an executive financial advisor to determine the best strategy to identify and pursue an exchange fund. Because an exchange fund is not an over-the-counter financial product, rather an ad-hoc project, it’s important to work with an advisor that has experience with this type of arrangement.
Exchange funds are typically set up in conjunction with other investors. Sometimes, these investors approach each other with this type of idea. Other times, large financial institutions and advisors will approach investors with large concentrated stock positions. However you begin this journey, an advisor can help you navigate through from start to finish.
There are also other options that can help diversify your investment portfolio as well. One you may consider using in addition to an exchange fund is an index proxy strategy, which postdates the exchange fund strategy. Let’s take a look at this diversification tool in further detail.
Using an Index Proxy Strategy for Concentrated Stock
An index proxy strategy is a method executed by wealth managers using specialized software to lower your concentrated stock exposure. The software helps establish a complex strategy of selling concentrated stock and purchasing other assets in the same account. Part of this strategy accounts for taxable incidents and attempts to minimize the amount of taxable gain by emphasizing long-term gains rather than short-term gains, which can trigger larger tax bills.
An index proxy account (an account filled with concentrated stock with the intent to diversify) could be used in addition to an exchange fund. While exchange funds can be a great solution to instantly diversify concentrated stock, complex strategies implemented with the use of software, such as an index proxy, can help diversify your portfolio over the course of years. This helps ensure that you optimize your taxable gains and harvest losses to help offset gains both now and in the future.
Using an index proxy account, your advisor could help you sell off your concentrated position over the course of 12 months or over the next five years. This all depends on your unique situation and the strategy that you and your advisor agree on.
Experts in Concentrated Stock Solutions
Choosing the right advisor is just as important, if not more so, than choosing the right strategy to diversify your stock position. Concentrated positions in anything can cause an increase in risk, no matter the industry. In the case of McDonald’s, the company sought out the help of a tenured hedge fund manager with experience in diversification and hedging against risk. In the same way, you should seek out an experienced financial advisor who specializes in helping top-level executives with concentrated stock positions. In doing so, you can feel confident you have a strategy in place to minimize risk, as well as taxation, through concentrated stock solutions.
K. Wade Carpenter, CFP®, AIF®, ChFC®, CLU®, is an innovative wealth manager serving corporate executives and entrepreneurs from coast to coast. Throughout his more than 25-year career, Wade’s focus on C-level clients has made him a top strategist for portfolio diversification, asset allocation, and equity compensation planning. For more information on how Wade and the Carpenter Team can advise you on using exchange funds for concentrated positions, reach out today for a complimentary consultation.
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