The exchange fund 7-year "lockup" is likely a myth
Investors often have liquidity... with some conditions
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Disclaimer: This is educational content. It is not investment, tax, or legal advice. It is not an endorsement of any strategy or product vendor. Consult an adviser about your particular circumstances, the partnership in question, and the conditions, risks, and tradeoffs.
It’s fashionable to dunk on exchange funds for lack of liquidity.
A traditional exchange fund is a partnership that accepts individual stocks from several different persons, forming a more or less diversified portfolio without incurring tax, in exchange for partnership interests.
Exchange funds have been around for decades and are popular for their simplicity and how fast they transform a concentrated public stock position into more diversified exposure.
That said, many advisers don’t like exchange funds because they feel their clients’ assets have to trudge through a 7-year “lockup.”
“The tax law requires a 7-year holding period for the tax benefits,” Srikanth Narayan, the founder of Cache, which manages several exchange funds, told me, while also explaining it’s possible for “an investor can get out with their stock a month after joining.”
The point of this article is to make the case that “lockup” is likely a heavy-handed choice of words in this context.
But, there are several intertwined concerns partners need to weigh when exiting before the end of year seven:
It is usually possible to access liquidity before the end of seven years
There are usually fund disincentives meant to maintain the integrity of the fund by discouraging early exit
A partner will nearly always get their exact shares back
Any diversification benefits are gone
There might be some gain recognition depending on what is distributed
There may also be a reporting requirement if redeemed within 2 years
“Be careful when distributing marketable securities,” Martin E. Mooney wrote in a Frost Brown Todd blog post, which is why it’s important to have an adviser or attorney closely examine the facts and circumstances for the strategy and specific fund in question.
While there are other considerations (e.g., cost, customization, tracking error, etc.), the speed of diversification is compelling, and so the “lockup” is worth unpacking.
At the highest level, this boils down to tax rules and fund disincentives. This article talks mostly about tax rules as the motivating force for the seven-year investment, and briefly mentions fund rules, but saves that topic for a future article.
Where does the 7-year “lockup” idea come from? And what other rules should investors know about? That’s what we’ll get into next.