How CEOs Use Exchange Cash to Diversify Without Selling

For CEOs and founders who got rich off a single stock, it’s sometimes possible to have too much of a good thing.

While the tech stock boom means a windfall for employees at high-flying companies, it’s risky to have too much of your net worth tied up in one stock. Some advisors ascribe to the 10% rule of thumb – meaning that no stock or asset should make up more than 10% of the portfolio.

“It represents the biggest risk and the biggest opportunity for this client,” said Rob Romano, head of capital markets investor solutions at Merrill.

Founders and long-time employees who want to diversify their portfolios can face steep capital gains taxes when they sell long-held stocks in order to reinvest. Alternatively, they can contribute their shares to an exchange-traded fund (not to be confused with ETFs).

Exchange funds, also known as swap funds, pool shares from multiple investors, who receive a partnership interest or share of the fund. After a specified lockup period—usually seven years—investors can redeem their shares for a diversified basket of stocks equal to their stake in the fund.

While exchange-traded funds became mainstream in the 1970s, they have gained greater popularity more recently as the stock market has delivered strong returns, fueled in particular by the rise of artificial intelligence.

Many publicly owned technology companies are increasing their stock compensation to compete with AI startups for talent, said Eric Friedman, chief investment officer for Northern Trust’s wealth management business.

Exchange funds generally hold 80% of their assets in stocks and aim to mirror benchmark indices such as the London Stock Exchange index Standard & Poor’s 500 Or Russell 3000. The Internal Revenue Service requires that the remaining 20% ​​be held in unsecured assets, with real estate being the most popular option.

Steve Edwards, chief investment strategist in Morgan Stanley’s wealth division, said he sees clients increasingly using exchange funds as a wealth transfer strategy.

“What exchange funds help us do is narrow down the range of outcomes because one stock will have a very wide range of outcomes,” he said. “Imagine you’re 70 years old, and you have a stock that was great, but then it turns into a dumpster fire, and basically, you’re not able to pass on the legacy you were hoping for to your heirs.”

However, convincing clients to hedge their bets is often a difficult proposition, Edwards said.

“People remember the blessing the stock has been to them and their families, and they expect the blessing to continue,” he said. “What we have found in our research and work is that stocks that have outperformed actually tend to underperform in the future.”

He said clients usually contribute only a portion of their shares to an exchange-traded fund to take some chips off the table.

Exchange funds only accept accredited investors who are worth more than $1 million or who have earned income of more than $200,000 in the past two calendar years.

The lock-in period comes with a subtlety: If an investor redeems before seven years, he loses the tax benefits and may incur hefty fees. Instead of receiving a diversified basket of stocks, an investor typically gets his or her original shares back—up to the value of his or her interest in the fund.

Scott Welsh, chief investment officer at multifamily office Certuity, said he advises against using exchange-traded funds because of the lockdown period. He said there are more flexible ways to eliminate risk, such as collars, prepaid variable futures, or tax-loss harvesting through long and short positions. If liquidity is a client’s primary goal, borrowing against the stock is another solid option.