Diversify
Diversifying concentrated stock: Exchange funds vs Frec Diversify
6 min read
Holding a large position in a single stock can be common for founders, early employees, executives, and long-term investors. It can be rewarding if the stock continues to appreciate, but it also creates risk: the performance of one overweight position can take a toll on your portfolio.
You could sell your shares or donate them to charity, but selling may trigger a significant tax bill, and donating reduces your investable assets. For investors looking to reduce concentration risk while managing taxes, the question becomes: Is there a way to diversify without triggering a large capital gains tax bill?
Previously, exchange funds have been the primary choice for long-term, tax-aware investors. Today, there is a more flexible option. This piece compares exchange funds and Frec Diversify to help you determine which approach may better fit your situation.
What is an exchange fund?
An exchange fund allows you to swap your concentrated stocks for shares of a diversified fund without selling your shares or paying capital gains tax upfront.
Most exchange funds are structured as limited partnerships. When you contribute your shares, you become a limited partner and the fund manager takes control of the portfolio. Your stock is pooled with other investors’ and invested across a mix of assets. In return, you receive fund units equal to the value of what you contributed.
Compared to exchange-traded funds (ETFs), which can be bought or sold at any time, exchange funds typically require a long holding period. If you sell your shares earlier, you may lose the tax deferral status and incur additional fees or penalties.
What is Frec Diversify?
Frec Diversify allows you to transition your concentrated stock into a diverse index without selling and triggering up front capital gains tax.
Instead of contributing your shares to a fund, you keep ownership of your shares. Frec builds a portfolio around them using long and short overlays to bring your total exposure closer to a broad market index. The overlays are actively traded to harvest capital losses, which are used to offset any capital gains incurred as we sell down the concentrated stock over time. Proceeds are reinvested into the broader portfolio to attempt to bring it closer to the benchmark index.
Once your concentrated position has been diversified enough to more closely track the broader index, you’re left with a diversified basket of stocks that will continue harvesting losses over time that you can use to offset gains elsewhere.
Choosing between exchange funds and Frec Diversify
Both exchange funds and Frec Diversify aim to tax efficiently diversify from a concentrated position. What may be right for you depends on your priorities and long-term financial plan.
Below are some considerations to keep in mind when making the decision:
Eligibility
To participate in an exchange fund, you typically have to be an accredited or qualified investor. Accredited investors are generally individuals who earn over $200,000 per year, couples earning over $300,000 per year, or households with a net worth exceeding $1 million, excluding the value of their primary residence. Even if you qualify, funds are not always available, and they may not accept your specific concentrated position.
Frec Diversify is available directly through Frec today. All you need to do is create a Frec account, transfer your stock, set up your Diversify, and start the process. You can diversify up to 5 stocks at once. You cannot use Frec Diversify if your shares are subject to trading restrictions. This is most commonly an issue if you are still actively employed at the company.
Pricing
Depending on the provider, the minimum investment for exchange funds ranges from $100k to $1m worth of concentrated stocks.
Frec Diversify has a minimum investment of $100k in concentrated stocks, and you can diversify up to 5 stocks at once to meet the minimum.
Management fees for exchange funds range from 0.70%-2.00%, depending on the fund’s gross assets under management. After seven years in the fund, the annual management fee may drop.
Frec Diversify has a 0.60% annual fee plus plus 0.30% in post-tax financing costs. After diversification is complete, the annual fee is reduced to 0.50% plus 0.30% in post-tax financing costs. After diversification, the portfolio continues harvesting tax losses, which can be used to offset gains elsewhere and minimize your tax bill depending on market conditions and your individual tax situation.
Liquidity
As mentioned before, exchange funds typically require you to stay invested for seven years. During that time, some providers have a multi-year lock-up in which withdrawals are not allowed at all. Exiting early may forfeit the tax deferral benefit and may trigger additional fees and penalties. Even after the lock-up period ends, redemptions can be limited, and investors may receive either their proportional share of the fund’s current holdings or the current value of the shares they originally contributed, whichever is lower.
Frec Diversify does not have a lock-up period. You can withdraw at any time, and we’ll show you your estimated tax impact beforehand. You can also pause diversification or adjust your portfolio throughout the process.
Diversification timeline
Once you are accepted into an exchange fund, diversification happens immediately, and your exposure shifts to that of the pooled fund. Your original cost basis carries over. Taxes are deferred until you eventually redeem and sell your fund shares, at which point gains are calculated based on that original cost basis.
With Frec Diversify, your cost basis also transfers when you move your shares into your Frec account. Diversification happens gradually, and the speed depends on your cost basis and stock performance. Gains are realized over time as portions of the concentrated position are sold down, using harvested losses from the overlays to offset those gains. Concentration risk is reduced on day 1, and continues to go down as your shares are sold over time.
According to our historical simulations, a concentrated position with a 50% cost basis can be effectively diversified in approximately 2.9 to 4.7 years with minimal tax impact. You can see how long diversifying your concentrated stock could take here.
End result
When you exchange your concentrated stock, you receive shares of a diversified fund. To qualify for tax deferral under IRS Code Section 721, at least 20% of the fund’s assets must be invested in securities that are not publicly traded stocks or bonds. Thus, your share may include assets such as real estate or commodities in addition to other public equities.
With Frec Diversify, you end up with a portfolio of public equities. Portfolios are currently benchmarked to the Russell 1000, a US Large Cap index, with benchmark options coming soon. Since you own the individual stocks, you can also customize the index at any time by adding, excluding, or adjusting the weights of certain stocks or sectors.
Conclusion
If you are looking for a more tax-efficient way to diversify your concentrated stock, both exchange funds and Frec Diversify can be good options.
Exchange funds offer immediate diversification, but are not always readily available and require a multi-year commitment to maintain tax deferral benefits. Frec Diversify is built with flexibility and taxes in mind. It reduces concentration over time, keeps you invested during the transitions, and continues tax loss harvesting even after diversification is complete.
If you’re interested in using Frec Diversify, you can create an account in minutes or schedule a call with our team. If you already have a Frec account, go to the Invest tab to set up Diversify and begin the process.
As always, please consult a tax advisor to determine which approach is best for you.
Investing involves risks, including the risk of loss. A long short strategy introduces additional risks and may not be suitable for all investors. Please read Frec’s Margin Disclosure before borrowing.
