Exchange funds defer the tax on a concentrated position and charge a great deal for the privilege

The people who hold dangerously concentrated stock positions did not choose the concentration. They were paid in it, or founded the company, or inherited it from a parent who bought it in 1974. What they choose is whether to keep it, and that decision usually gets postponed for years because every route out starts with a tax bill.

The postponement has a cost that never appears on a statement. A single stock carries the market's risk plus its own, and only the first of those is compensated over time. The distribution of long horizon outcomes for individual shares is far worse than most holders assume, because memory selects for the survivors.

Twenty six percent of ten year windows ended in a loss, and another eighteen percent produced a gain of less than fifty percent over a decade, which is a real loss after inflation. Slightly under a quarter of windows produced the outsized outcomes that the whole category is remembered for. A holder with 70% of net worth in one name is making a bet with those odds whether or not they think of it that way.

The four routes, compared honestly

There are more than four products sold into this problem, but there are only four underlying mechanisms. Everything else is a wrapper around one of them.

The final row is the one advisers are reluctant to lead with and it is often correct. A holder aged 84 with a low basis position, adequate income from elsewhere and no need for the money is looking at a complete forgiveness of the embedded gain in the reasonably near future. Paying 23.8% now to avoid a risk they may not live long enough to bear is poor arithmetic, though it may still be good sleep.

Staged selling deserves more credit than it gets. Splitting a sale across four or five tax years keeps more of the gain inside the lower capital gains bands, avoids pushing a single year past the net investment income threshold, and pairs well with harvested losses from the rest of the portfolio. It is unglamorous, it requires no product and no counterparty, and for positions under roughly five million dollars it usually leaves the holder better off than any structure sold as an alternative to it.

How an exchange fund actually works

The structure exploits a specific provision: contributing appreciated securities to a partnership is not a taxable exchange, provided the partnership is not an investment company under the relevant test. To avoid that classification, at least 20% of the fund's assets must be non-qualifying, which means illiquid real property, usually a leveraged portfolio of apartment buildings or timberland.

So a contributor gets diversified equity exposure for roughly 80% of their money and a leveraged private real estate position for the other 20%, whether they wanted real estate or not. The partnership interest carries the original cost basis. After seven years the holder may redeem and receive a basket of shares from the fund's holdings, again without a tax event, and can then sell those individually as they wish.

The exchange fund beats the outright sale in this model, which is the argument the product is sold on. The margin is smaller than it looks, because the deferred gain is still owed and because the 20% illiquid sleeve is modelled at index-like returns, which is generous. Widen the fee to 165 basis points, or assume the real estate sleeve returns three points less than equities, and the two routes converge.

The question I ask first is not about tax. It is whether the client could fund everything they intend to do for the rest of their life if the position fell seventy percent tomorrow. If the answer is yes, we can be clever. If the answer is no, we sell enough to make it yes, and we stop being clever.

Julia Crane, head of concentrated wealth solutions at Lachlan Grove Partners

The half measure that usually wins

Most holders end up somewhere in the middle, and that is generally the right place. Sell enough to secure the spending plan, which for many families is a smaller number than they fear. Put a portion into an exchange fund if the basis is genuinely negligible and the seven years are tolerable. Direct the remainder of any charitable giving out of the concentrated position rather than out of cash, which converts a future tax liability into a deduction at full market value.

What should not happen is the default, which is to do nothing for a decade while telling yourself the tax is the obstacle. The tax is a known quantity that gets slightly worse with time. The concentration is an unknown quantity that has one in four odds of ending badly over the same period, and no product sold into this market removes that trade-off. They only change its shape.