What is a Restricted Stock Exchange Fund and How Does it Diversify Concentrated Stock Risk?

Owners of restricted stock that are affiliates, or control persons, have limited options for selling their restricted stock which creates a highly concentrated position for the shareholder. To diversify concentrated stock risk, an owner of restricted stock can participate in an exchange fund, also known as a swap fund. Exchange funds offer the shareholder a unique opportunity to diversify their concentrated position of restricted stock in a single company, while certain exchange funds even allow the shareholder to share in the upside and set aside funds for taxes. In this article we will explain what is a restricted stock exchange fund and how it diversifies concentrated stock risk, as well as the different types of exchange funds available.

The Definition of a Restricted Stock Exchange Fund

An exchange fund, also known as a swap fund, is a private placement limited partnership where a shareholder exchanges, or swaps, their shares of restricted stock for shares in a fund of many stocks pooled together.

What are the Benefits of an Exchange Fund?

Since there are limited options for affiliate owners of restricted stock for diversification and monetization, exchange funds that accept restricted securities can be incredibly valuable.

  • Once you swap your restricted stock into the exchange fund you are able to immediately diversify a concentrated stock position that you would otherwise have difficulty selling due to Rule 144 restrictions set in place by the Securities Act of 1933. By accepting shares from shareholders in many different companies, the exchange fund essentially becomes a diversified holding of stock similar to an index. This creates much needed diversification for restricted stock owners.
  • By exchanging shares in an exchange fund instead of selling stock, a shareholder is able to defer taxes that would otherwise have been paid after a sale. Since shareholders are not paying the 23.8% capital gains tax on the sale of restricted stock, they can get a higher stake in the exchange fund than a traditional investment allowing for more potential growth.
  • If the exchange fund outperforms the individual restricted stock, the shareholder benefits greatly from the exchange.

What are the Disadvantages of an Exchange Fund?

There are disadvantages associated with a traditional exchange fund that accepts restricted securities.

  • Generally, exchange funds require restricted stock to remain in the exchange fund for at least seven to ten years. Thus, putting restricted stock in the exchange fund doesn’t improve the illiquid nature of the stock.
  • Exchange funds typically reinvest the dividends from the swapped securities in exchange for management of the fund.
  • Traditional exchange funds charge high management fees which will eat into profits.
  • If the exchange fund underperforms the stock that was swapped into the exchange fund, a shareholder would miss out on the performance of their individual stock.
  • Not all restricted stock qualifies for the exchange fund. Most exchange funds have limits to the percentage of shares in any one company as well as requirements for the value of the stock, which exchange it trades on, and more.
  • Traditional exchange funds do not plan for future taxes or preserve principal. This can lead to hefty tax bills when leaving an exchange fund.