Sharon Olson is the Founder & President of Olson Wealth Group, Inspired Life Family Office®, a multi-family office & wealth management firm.
When Susan, a high-level executive at a successful tech company, looked at her portfolio, her heart sank. Despite the immense wealth her company’s stock had generated, she faced an alarming reality: Over 80% of her holdings were tied to a single, volatile asset. The risk of losing everything in a downturn kept her up at night. But like many high-net-worth individuals, Susan wasn’t just concerned with diversification—she also had to navigate the complex landscape of tax management. How could she spread her wealth across a variety of assets while avoiding significant tax burdens?
One solution lies in two increasingly popular strategies: exchange funds and direct indexing. While both approaches offer a way to reduce concentration risk and optimize tax efficiency, they differ in structure and suitability. Here’s a closer look at how each strategy helped Susan preserve her financial future.
Concentration Risk: A Hidden Threat
Concentration risk occurs when an investor’s portfolio is overly reliant on a few assets, often the result of stock options, inheritance or entrepreneurial ventures. This risk can lead to steep losses if those concentrated stocks suffer a downturn. For Susan, the solution was clear: She needed to diversify. But diversification alone wasn’t enough—she needed to avoid triggering an astronomical tax bill, which could arise from selling her concentrated shares.
Exchange Funds: Diversification Without The Tax Hit
Exchange funds, or swap funds, provided Susan with a structured way to reduce her concentration risk. These private investment vehicles pool assets from multiple investors, enabling participants to exchange concentrated stock holdings for a diversified portfolio.
For Susan, the appeal was immediate diversification without incurring capital gains taxes. By transferring $1 million worth of her company’s stock into an exchange fund, Susan could diversify into a range of industries, including real estate and equities. Additionally, the tax-deferral benefit allowed her to delay paying capital gains tax on the transfer. As she put it, “It’s like breathing room.”
However, exchange funds come with their own set of trade-offs. They typically require long holding periods, often seven years or more, before assets can be redeemed. In addition, these funds are generally reserved for accredited investors and come with hefty fees, which may limit accessibility for some.
Direct Indexing: Customization And Control
While the exchange fund strategy worked for part of Susan’s holdings, she also sought more control over her investment strategy. Enter direct indexing—a technique that allows investors to buy individual stocks mirroring the performance of an index, such as the S&P 500.
Direct indexing offered Susan several advantages. First, it allowed for tax-loss harvesting, where she could sell individual stocks at a loss to offset gains in other areas of her portfolio. Second, the customization offered by direct indexing allowed Susan to exclude certain stocks or sectors, ensuring her portfolio aligned with her personal values and long-term goals.
The main drawback? Direct indexing is more complex and requires time, expertise or access to advanced advisory services. Additionally, investors typically need a larger portfolio to take advantage of this strategy, with minimum investment amounts often starting at $250,000.
Striking The Right Balance
In Susan’s case, the right solution was a combination of both strategies. She used the exchange fund to address a significant portion of her concentrated position, securing immediate diversification and tax deferral. Meanwhile, she implemented a direct indexing strategy to maintain more granular control over her portfolio, maximizing tax efficiency and tailoring it to her specific preferences.
Both exchange funds and direct indexing have proven to be effective tools for mitigating concentration risk and optimizing taxes. The key is understanding each approach’s unique advantages and limitations and choosing the one that best suits your individual needs. As Susan discovered, a well-crafted strategy can provide not only confidence but also the financial flexibility to continue building wealth for years to come.
Securities and Advisory Services offered through LPL Financial, a Registered Investment Advisor. Member FINRA/SIPC. The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
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