Traditional Ways of Handling Concentrated Positions

With the S&P 500 up more than 200% over the past 10 years, many investors have portfolios that contain highly appreciated stock positions, which may result in significant concentration risk. Traditionally, to diversify these positions and reduce that risk, an investor may sell a portion of the stock, employ an exchange fund, ¹ or donate appreciated securities.

For some investors, these options may not be a great fit for their situation. First, if there is a high likelihood that the investor may not need to sell the appreciated positions during their lifetime, they could realize capital gains they otherwise may not need to and end up paying more taxes than necessary. Second, many exchange funds are unable to accept many of the most popular concentrated stocks investors may have (Nvidia, Meta, etc.) because the funds already hold too much of those stocks.

A New Diversification Tool

Another diversification investment vehicle to consider is a Section 351 exchange fund. Although Section 351 exchanges have been around since the 1950s, the concept has recently begun to be applied to individual investment portfolios. This new strategy introduces the ability for investors to receive tax deferral while also diversifying some or all of their concentrated positions. 

Mechanics of Section 351 Exchanges

A Section 351 exchange fund combines investments from multiple investors and uses these funds to launch a new exchange traded fund (ETF). Assuming the exchange fund meets Section 351 requirements, this transaction does not trigger any tax consequence. One thing to note is that tax deferral only occurs if the investor is an investor in the ETF at its launch.

At the end of the transaction, investors have a diversified ETF instead of concentrated stock positions. The shares of the new ETF carry over the same potential tax liability as the concentrated stock positions but reduce company-specific risk associated with holding a large portion of their portfolio in single stocks.

Diversification Rules

Unlike traditional exchange funds, Section 351 exchange funds do have some diversification rules that need to be considered. To be eligible for a Section 351 exchange fund, an investor must contribute a basket of securities that follow certain rules, including that any one asset may not make up more than 25% of the total contribution value and the top five holdings may not exceed 50% of the contribution value.

Investment Example

Let’s consider the following example: An investor has accumulated an investment portfolio worth $6 million. Within their portfolio, they hold seven concentrated stock positions, each having a current market value of $275,000 and were purchased for $25,000 apiece. These positions comprise roughly a third of the investor’s portfolio. 

Wanting to further diversify their portfolio, the investor decides to contribute these concentrated positions, along with some cash and other investments (to meet the diversification rules), to a Section 351 exchange fund. In total, the investor contributes $3 million worth of investments that have a cost basis of $1 million. 

Once the investments are contributed, the fund manager swaps these positions for a basket of stocks based on the fund’s investment objective (e.g., broadly diversified index fund). The investor now owns $3 million worth of shares of an ETF that has the same tax characteristics as their previous holdings. 

Section 351 Exchange Landscape

Section 351 exchange funds represent a relatively new investment diversification tool that is starting to pick up more traction as fund managers understand the demand for diversifying concentrated positions. As we see more adoption, it will be interesting to see how Section 351 exchange funds evolve and if they are suitable for more investors.

1. An exchange fund pools individual stock positions from various investors. These funds operate under Section 721 of the Internal Revenue Code.