Definition of exchange fund

What is a swap fund?

A swap fund, also known as a swap fund, is an arrangement between concentrated shareholders of different companies that pools stocks and allows an investor to exchange their large holding of a single share for units of the entire portfolio. Swap funds give investors an easy way to diversify their holdings while deferring capital gains taxes.

Exchange funds should not be confused with exchange-traded funds (ETFs), which are mutual fund-like securities that are traded on stock exchanges.

Key takeaways

  • Exchange funds group large numbers of concentrated shareholders of different companies into a single investment group.
  • The purpose is to allow the large shareholders of a single corporation to exchange their concentrated stake in exchange for a stake in the group’s more diversified portfolio.
  • Swap funds are particularly attractive to concentrated shareholders who want to diversify their otherwise restricted holdings.
  • They also attract large investors who have highly prized stocks that would be subject to large capital gains taxes if they were to seek to diversify by selling those stocks to buy others on the market.

How exchange funds work

The exchange fund takes advantage of the existence of several investors in similar positions: they hold concentrated equity positions and want to diversify. Several investors pool their shares in a company and each receives a prorated share of the exchange fund. The investor now owns a portion of a fund that contains a portfolio of different stocks, allowing for some diversification. This approach not only achieves some diversification for the investor, but also allows for tax deferral.

Since an investor trades shares with the fund, no sale actually occurs. This allows the investor to defer paying capital gains taxes until the fund shares are sold. There are public and private exchange funds. The former offers investors a way to diversify private equity holdings, while the latter offers stocks containing publicly traded companies.

Exchange funds are designed to primarily attract investors who previously focused on building concentrated positions in restricted or highly appreciated stocks, but are now looking to diversify. Typically, a large bank, investment company, or other financial institution will create a fund, aiming for a certain size and mix in terms of the shares being contributed.

Participants in a swap fund will contribute some of the shares they own, which are then pooled with the shares of other investors. With each contributing shareholder, the portfolio becomes more and more diversified. A swap fund can be marketed to executives and business owners, who have accumulated positions that typically focus on one or a handful of companies. Participating in the fund allows them to diversify those highly concentrated equity positions.

Exchange fund requirements

Funds exchanged may require potential participants to have a minimum liquidity of $ 5 million in cash to join and contribute. Swap funds also typically have a seven-year lock-in period to satisfy tax deferral requirements, which could pose a problem for some investors.

As the fund grows and when enough shares have been contributed, the fund closes to new shares. Each investor is then awarded an interest in the class actions based on their share of the original contributions. Fund shares transferred to the exchange fund are not immediately subject to capital gains tax.

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

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Mark Holland

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