How an exchange fund unblocks billions by seeding an ETF in-kind

Investors denied by incumbent exchange funds have a disruptor to consider

Note: This post is not investment, tax, or legal advice. Tax Alpha Insider independently produced it. See full disclosure at the end.

A few weeks ago, I received a cryptic email

An ETF I'm following said it would delay launching due to a “new concept” that could help investors with concentrated stock positions.

The giveaway was in the email subject line: “What is a 351 Exchange? 351 + Exchange Fund? AAUS Launch Update.”

I wrote a short book about the 351 exchange, so I understood that part.

But what did the ETF have to do with an exchange fund?

I called Wes Gray at Alpha Architect for the details.

They were delaying the launch of AAUS because they anticipated a contribution from an unusual source, an exchange fund, namely a Cache exchange fund.

Investors denied by other exchange funds and those skeptical of exchange funds altogether will soon have a powerful tool to consider in their quest to de-risk concentrated stock positions tax-efficiently.

But let’s start from the beginning.

What is an exchange fund?

An exchange fund (not an exchange-traded fund) is a partnership that receives assets (usually single stocks, but not always) from individuals from which it constructs a diversified portfolio. After seven years, investors can withdraw a diversified portfolio with the same cost basis they originally contributed.

Exchange funds are an important tool for investors wishing to diversify concentrated positions immediately, but less so for those requiring liquidity (although many exchange funds offer early withdrawal for a fee, and investors often pledge their partnership interests as collateral for loans).

This post is about the exchange fund industry, not exchange fund basics, so I’ll refer you to these excellent resources to get you up to speed:

• Mike Allison (New Lantern): Exchange Funds 2.0: A Newly Accessible Way to Diversify Concentrated Positions

• The incumbents, including Morgan Stanley/Eaton Vance, and Goldman Sachs among others

• The disruptor: Cache (and what is an exchange fund?)

• The critique: “Am I the Only Person Paying Taxes? The Largest

  Tax Loophole for the Rich - Exchange Funds”

Why would an exchange fund seed an ETF?

“Capacity was rarely available for the stocks investors actually want to diversify,” Srikanth Narayan, Cache’s founder and CEO, told me.

An exchange fund must balance accepting assets and the extent to which it is willing to deviate from its benchmark.

A higher tolerance for deviation means it can accept more concentration and a wider variety of assets. Still, the exchange fund will eventually run out of room for more Nvidia or smaller names (which could be a tiny part of the benchmark or possibly only correlated with the benchmark), and it will simply reject new investors.

These are the billions Cache’s exchange fund hopes to unblock by seeding an ETF with fund assets.

How does it work?

How an exchange fund seeds an ETF

Investor → Exchange Fund

• Investors contribute low-basis stock (no capital gain is recognized)

• They receive a partnership interest

• Investors are, more or less, immediately diversified¹ since many individuals contribute different shares

• The exchange fund borrows against its portfolio to purchase illiquid real estate

Exchange Fund → ETF

• The exchange fund contributes a diversified basket of shares to a new ETF at launch (via Section 351, a one-time thing)

• The exchange fund now holds an ETF rather than a hodgepodge of individual shares (though there will still be some individual shares). It still holds the real estate

Exchange Fund → Investor

• After seven years, investors may withdraw ETF shares

• Their cost basis has not changed, but they’ve deferred taxation while their assets grew in the exchange fund

The perks of holding an ETF

There are several advantages to an exchange fund holding an ETF over individual shares. I’ll quickly list them here before returning to the bigger picture:

• Liquidity

• Diversification

• Transparency

• Cost efficiency

• Lower tracking error

• Tax-efficient rebalancing (via in-kind redemption)

• And what I’m starting to call “tax optionality”: harvesting losers, redeeming winners in-kind

But the real unlock is in all the additional investors the exchange fund can support.

If an incumbent exchange fund has capacity limits, why doesn’t Cache?

For Cache to seed an ETF in-kind, it needs to follow the rules in Section 351, namely the 25/50 diversification rules (not >25% in one issuer, not >50% in five issuers) and that the seed must be aligned with the ETF’s investment policy statement (there’s wiggle room around what is “aligned”)²

If the exchange fund meets those rules, it can contribute its portfolio (or a subset also meeting the rules) as in-kind seed capital for the ETF without recognizing a capital gain.

So, rather than limiting access to the fund to manage portfolio tracking error, the exchange fund can accept any assets as long as they pass all of Section 351’s rules.

Once the assets are in the ETF wrapper, the ETF will gradually (1-12 months is normal) transition the portfolio from seed to ideal state.

The bottom line is that Cache still has capacity limits, but they are far more relaxed than those used by other exchange funds since an ETF can minimize tracking error very efficiently.

It’s still an exchange fund

Beauty is in the eye of the beholder.

An exchange fund is an important tool for investors looking to diversify concentrated stock positions quickly, but that might not be an investor’s top priority.

Before outlining the drawbacks, it’s worth noting that many of the operational complaints surrounding exchange funds - such as high minimums, qualified purchaser status, the need for a wealth adviser, high fees, clunky reporting, and a lack of portfolio transparency, etc. - are largely solved. Many by incumbent exchange fund managers, and nearly all by Cache. Investors will likely always pay more fees for an exchange fund, as it costs more to operate.

These are the biggest issues most investors have with exchange funds:

1. The 7-year holding period

2. Real estate in the portfolio

3. The investor’s cost basis is the same when they exit the fund

The 7-year holding period

For some folks, seven years is a long time; for others, it is not.

Some wealth managers I’ve spoken with recently describe a “liquidity budget,” which is often dominated by venture capital, private credit, and equity, hedge funds, railcar leasing arrangements, mobile home exposure, whatever, and they simply lack the room (cash or energy) for more illiquid investments in client portfolios.

On the other hand, Srikanth argues, “For many advisors, the largest ‘illiquid’ asset in many clients' portfolios is their concentrated stock, and it is not even under the advisor's discretion / AUM,” which I’ve also heard from several advisers, and is a compelling opportunity for those seeking to migrate non-discretionary assets to discretionary by offering an exchange fund.

Real estate

“Your client may not want to add a large real estate allocation to his existing portfolio- especially one that equals at least 25 percent of the value of the concentrated position to be invested (so that that illiquid position is 20 percent of the whole),” Tim Kochis wrote in his Managing Concentrated Stock Wealth³. Not because the real estate is low quality (though that’s worth including in diligence), but because it has a different risk profile.

Again, this isn’t a universal problem. Some folks may appreciate the diversification benefits of additional real estate exposure, but an exchange fund might be a turn-off if they’re already over-exposed to real estate.

Cost basis

While an investor has achieved diversification and tax deferral, laudable goals, they still have low cost basis positions when they exit the exchange fund. There are plenty of options for dealing with low basis assets tax-efficiently (including, tax-aware long/short strategies, hedging, and gifting, all of which come with tradeoffs), so it’s worth carefully considering the pros and cons of each solution and perhaps combining them to optimally manage cost basis through an investor’s lifetime.

If an investor plans to take advantage of step-up in basis at death, then low basis stock is not a concern.

The exchange fund wrapper

One of the benefits of the exchange fund is how easy it is to explain to prospects and clients and to plan around.

It has drawbacks, like any investment vehicle, but it may be the right solution for the right investor.

Converting individual equities into an ETF makes the pitch to amenable investors more compelling.

I’m curious to see if it convinces investors unpersuaded by exchange funds in the past to change their minds.

Thanks for reading.

Disclosure: This post was independently produced by Tax Alpha Insider. Cache Financials Inc. paid for a license to share this content publicly. They had no editorial input and were not involved in its production.

---

APPENDIX

Is an exchange fund seeding an ETF a scheme to achieve diversification?

I am not an attorney. I am not providing investment, tax, or legal interpretation or guidance. But I have a few questions as I diligence an exchange fund seeding an ETF.

At issue here is whether the exchange fund’s contribution to an ETF is a “plan to achieve diversification” or does so “directly or indirectly” for exchange fund investors contributing concentrated positions.

Why does this matter?

Transfers to an investment company, including a partnership that would be treated as an investment company if it were incorporated, generally result in recognized capital gain under § 351(e) and §721(b).

However, both statutes provide exceptions where diversification is not achieved through the transfer:

• § 351(e)(1): No gain if the contributed assets are already diversified under the 25/50 test (not >25% in one issuer, not >50% in five issuers).

• § 721(b): No gain if the transferee partnership fails to qualify as an investment company, e.g., because >20% of its assets are illiquid, so it doesn’t meet the 80% “readily marketable securities” test.

These exceptions are generally interpreted to mean that the contribution is not to an investment company, so the anti-diversification rule doesn’t apply and no gain is triggered.

Again, I’m not an attorney. Investors should confirm these things with their tax adviser, legal counsel, and, ultimately, Cache.

“Plan to achieve diversification”

To avoid recognizing gain, investors must avoid achieving diversification. They do this by already being diversified or holding illiquid assets, so they never get diversified.

However, a 2009 IRS PLR says the following:

Section 1.351-1(c)(5) provides that a transfer ordinarily results in diversification of the transferors' interests if two or more persons transfer nonidentical assets to a corporation in the exchange. It further provides that, if a transfer is part of a plan to achieve diversification without recognition of gain, such as a plan which contemplates a subsequent transfer, however delayed, of the corporate assets (or of the stock or securities received in the earlier exchange) to an investment company in a transaction purporting to qualify for nonrecognition treatment, the original transfer will be treated as resulting in diversification.

If the contribution to the exchange fund does not trigger gains recognition because it does not result in diversification, does a subsequent transaction cause diversification?

It appears unlikely, based on two factors:

1. The exchange fund still holds illiquid real estate

2. Converting individual equities to an ETF will not achieve diversification

In other words, the §721 non-diversification is the dominating factor. Diversification has not technically been achieved.

But I’m speculating, and investors should put these questions directly to Cache tax counsel as part of their diligence process.

“Directly or indirectly”

The same PLR also says the following:

Section 1.351-1(c)(1) of the Income Tax Regulations provides that a transfer to an investment company will occur when (i) the transfer results, directly or indirectly, in diversification of the transferors' interests and (ii) the transferee is a regulated investment company ("RIC"), real estate investment trust ("REIT"), or a corporation more than 80 percent of the value of whose assets (excluding cash and non-convertible debt obligations from consideration) are held for investment and are readily marketable stocks or securities, or interests in RICs or REITs.

If I had to guess, the argument for no gain recognition is nearly the same as above:

1. Contribution of a concentrated position to an exchange fund is not a contribution to an investment company for normal exchange fund reasons (i.e., holding illiquid real estate, more or less). Therefore, no gain recognition is triggered.

2. Next, an exchange fund’s contribution of assets to an ETF is also not a contribution to an investment company because the portfolio passes the 25/50 diversification (and other) tests. Therefore, no gain recognition is triggered.

3. After the Section 351 conversion of exchange fund assets, which only impacts individual equity positions, the exchange fund still holds illiquid real estate, so investors in the exchange fund have not achieved diversification (no more so than when they made the initial exchange fund contribution).

Again, the §721 non-diversification appears to be the dominating factor. Diversification has not technically been achieved.

One potential interpretation is that if diversification is never achieved, the plan alone may not matter, which could make these concerns moot.

But, I am not a lawyer, and investors should consult the guidance of a credentialed professional and tax specialist to wade through these things.

1. Investors are diversified from an economic standpoint but not technically diversified from a tax standpoint. See the appendix for more on this.

2. There are other rules, like the 80% control provision, and unofficial rules, like the ETF must be able to redeem the seed assets in kind with an Authorized Participant, but they’re not material for the topic at hand.

3. While I adore Kochis’ book, the chapter on exchange funds is a little iffy. He suggests that “Real estate used to meet a tax requirement… is not likely to be the kind with the very best investment characteristics,” which is too broad an opinion for my taste. The folks at Eaton Vance, which manages the real estate portfolio used in its exchange funds, would likely beg to differ.

Kochis also argues that “This dilution of opportunity can be far more costly than the 23.8 percent federal capital gains tax, which is the most that would be taken on an outright sale.,” which is suspect for two reasons: 1) the real estate slice of the portfolio is invested on margin, and 2) 23.8% is the federal marginal long-term capital gains rate, but some may pay much higher marginal rates if their state does not have preferential status for long-term capital gains, as is the case in California.