Exchange funds vs. direct indexing for large stock positions

A concentrated position (more than 10% of your net worth in a single stock) can be a good problem to have. It means something has gone really well for you – whether you’ve invested in the right companies or earned stock compensation from them. However, it also means you’re subject to concentration risk that can take your net worth on a roller coaster ride.

Diversifying your portfolio helps reduce your risk, but you might balk at the giant tax bill you would incur if you sold. Fortunately, there are several investment strategies designed to help you diversify tax-efficiently.

Enter exchange funds and direct indexing

In this post, we compare two popular strategies that might come up when you research diversifying a large stock position – exchange funds and direct indexing. Both are sophisticated vehicles, so weighing the pros and cons to choose the best strategy can be complex.

That’s why we did the homework for you.

Exchange funds

‍‍Exchange funds work by pooling together stocks from multiple investors into a communal fund. The fund accepts stocks in specific quantities to achieve a target investment objective, typically resembling the composition of a diversified index fund like the Nasdaq-100 Index or the S&P 500 Index. In exchange, each participant gets a pro-rata share of the fund.

No capital gains taxes are triggered when the fund is created, so an investor’s entire principal can grow without being subject to tax drag. After seven years, investors may choose to redeem their share in the fund for a diversified basket of stocks without paying capital gains taxes. No taxes are due until the basket of stocks is eventually sold, which can result in a significant performance advantage over time.

Since it is logistically challenging to assemble a group of investors with a set of stocks that’s weighted exactly the same as an index fund, exchange funds approximate the composition of their target index through various quantitative measures, resulting in a certain "tracking error".

Direct indexing

Direct indexing works by purchasing the entire basket of stocks that makes up a diversified index fund (instead of ETF or Mutual Fund shares). As stocks in the index naturally fluctuate, it presents opportunities to offset the gains of some stocks with losses from others through a technique called "tax-loss harvesting". 

By passing tax losses back to the investor, direct indexing can offset some of the tax burden they incur when selling off their concentrated position. As those harvested losses accrue over time, it allows the investor to diversify more and more of their concentrated position.

A significant cash infusion is typically required to initiate the program – or some of the concentrated positions must be sold (and taxes paid) upfront. When selling stocks to harvest losses, the investor cannot immediately repurchase them due to Wash Sale rules, so the composition of a direct index portfolio will not always match the target index. This situation also leads to tracking error, which can be significant if a rapidly rising stock is sold and can’t be repurchased.

Consider these seven factors

So, which approach is right for you? Both direct indexing and exchange funds have benefits and drawbacks for diversifying a concentrated position. Choosing the best strategy really depends on your investment outlook, your liquidity needs, and your risk tolerance. Here’s a closer look at the factors that may affect your decision.

1. The cost of diversification

How much does it cost to transition from a single stock to a diversified basket? Both strategies are designed to outperform a simple "Sell and Reinvest" approach, but there are nuances to consider.

An exchange fund allows for a transition to a diversified basket without triggering taxes. When you hold a stock with significant appreciation, whether in percentage or absolute dollar value, diversification would mean a giant tax bill. As a rough rule of thumb, we suggest that exchange funds have strong benefits when your stocks have appreciated 50% or more.

On the other hand, a direct indexing program generates tax losses to offset gains on individual stocks. Using tax losses to offset gains could be beneficial when using a direct index as an alternative to a traditional index fund because it generates tax alpha that is shown to improve after-tax returns by around 1% per year.

However, it may not be the optimal strategy when trying to diversify a stock that has appreciated significantly. Investment losses, regardless of how they are marketed, are generally undesirable. For example, a position with $1M in capital gains would require $1M in capital losses to offset the tax burden. In this case, while an investor avoided the taxes on $1M in gains, they also experienced $1M in actual losses.

Additionally, active trading within the index to generate tax losses can have unintended consequences. Depending on the aggressiveness of the direct indexing program, winners could be sold too quickly, or losses might be harvested on a slight downward trend. Given Wash Sale rules – which require a 30-day wait between selling and repurchasing the same stock – your portfolio could be left unexposed or underexposed to the stocks sold, which could result in significant tracking errors.

For example, in 2021, Meta’s stock price plummeted from $338 per share to $88. In 2022, it skyrocketed, starting the year at $124 and ending at $353. Had an investor sold Meta in 2021 to tax-lost harvest some winners, the temporary dip in Meta’s stock price would have resulted in an investor missing out on a longer-term winner.

Takeaway: Exchange funds are more effective when you hold stocks with significant gains, whether in terms of percentage or absolute dollar value. On the other hand, direct indexing may be more suitable for offsetting smaller gains or when the long-term nature of an exchange fund is a concern.

2. Time required to diversify

How long does it take to transition from a single stock to a diversified position? Both of these strategies are slower than simply selling and reinvesting, but the wait might be worth it, depending on your outlook.

An exchange fund diversifies an investor’s portfolio immediately upon investment. For example, if you contribute $1M of Microsoft stock (MSFT) to an exchange fund, you would receive a diversified portfolio of fund shares worth $1M at the moment the fund is created. Note that exchange funds are not open for investments at all times, so there could be a delay before an investor is invited to participate.

A direct indexing program diversifies a single-stock exposure by selling away the concentrated position as tax losses are harvested. Depending on the extent of built-in gains and the size of the index portfolio, it could take several years or decades to generate enough losses to offset the gains in your concentrated position. Beyond a certain threshold, achieving diversification through a direct indexing solution might not be attainable.

‍Takeaway: Exchange funds diversify you upon participation, immediately reducing your exposure to the concentration risk in your portfolio. direct indexing could take years or decades to achieve the same result, and attempting to speed up loss harvesting might lead to undesirable results.

As a quick rule of thumb, we generally recommend that a direct indexing option is better if your stock position has appreciated less than 50%, and an exchange fund might be worth considering when your stock position has appreciated more than 50%.

3. Liquidity constraints

Exchange funds allow an investor to diversify faster than direct indexing, but it’s also worth asking how long it will take until investments are liquid under each program.

Exchange funds are a long-term investment product, period. The current tax code requires at least a seven-year holding period before an investor is able to redeem a diversified portfolio. Within the first seven years, exchange funds can only distribute your original stock back to you (and there may be penalties or other limitations on your ability to redeem early).

Direct indexing programs can be initiated and wound down upon investor request (though this is rarely as simple in practice as it sounds). That means liquidity can be reached at any time, but exiting early also means you could still hold a concentrated position – and that you’d have hundreds of individual stocks to manage.

‍Takeaway: Per the tax code, exchange funds require a seven-year commitment to realize the benefits, and liquidity before the end of that period is limited. Direct indexing offers flexible liquidity.

4. Capital needed to diversify

How much capital needs to be deployed to diversify your position? It varies dramatically with these two strategies.

With an exchange fund, all you do is contribute stock to a communal fund alongside other investors, providing diversification through participation. You can invest an amount that you feel comfortable with, and no additional capital is necessary. Note that exchange fund brokerages may require a minimum investment. For example, the Cache Exchange Fund typically requires a $100K contribution, while the minimum may be $500K - $1M for other providers.

With direct indexing, you’ll need to deploy sufficient capital to create a portfolio that’s big enough to offset the gains in your stock position. If the size of the capital contribution relative to the concentrated stock isn’t large enough, it further increases the time to achieve the preferred level of diversification. Over a 10-year period, research shows that you generate 30% of the deployed capital in tax losses, which means that the strategy can only be effective when the capital available to deploy is several times the size of your concentrated position. Though the concentration risk isn't a major concern for the investor in question.

Takeaway: Exchange funds do not need any additional capital infusion, whereas an investor needs to make a substantial cash contribution (or sell and pay taxes on some of their concentrated stock) to get a direct indexing program started.

5. Options for a target index

How much choice do you have when you choose an exchange fund or direct index?

Each exchange fund is formed with a specific index in mind – then fund managers seek investors who can contribute stocks that approximate the composition of that index. As a result, the universe of investable indices with exchange funds is very low. Legacy exchange fund providers target broad market indices like the S&P 500, S&P 1500, or Russell 3000. At Cache, we offer exchange funds that are benchmarked to the NASDAQ-100 index.

A direct indexing program can be spun up to target any index or investment objective, so investors have a high degree of flexibility in index selection, as well as sectors or stocks to exclude or include.

‍Takeaway: Exchange funds are only available for a small set of well-known indices, while direct indexing can be customized around any investment preferences.

6. What happens at redemption

Once the concentrated stock is diversified (and in the case of exchange funds, the seven-year maturation period is reached), you’ll have the option of redeeming your shares. Here’s what that looks like with each strategy.

Exchange funds distribute, without triggering taxes, a diversified basket of stocks that the investor can continue to hold until they are ready to sell. Across providers, you can expect 15-30 stocks to be part of the distribution. Given that the original cost basis is applied to this new basket, there may be ample opportunities to tax-loss harvest the appreciated assets within the distributed basket if liquidity is desired.

Direct indexing programs usually distribute the set of stocks that were bought to replicate the index. Since these programs are continuously scanning for loss harvesting opportunities within the portfolios, the level of tax-loss harvesting possible with the distributed portfolio is likely to be minimal.

‍Takeaway: In both cases, you receive a basket of stocks upon redemption. With an exchange fund, there may be additional opportunities to tax-loss harvest to offset the appreciated assets within the distributed basket.

7. Overall tax advantage

Which strategy gives you a bigger tax advantage (or “tax alpha”)? Well, it depends on your financial situation, your investment outlook, or how your tax rate is likely to change over time.

An exchange fund can help you diversify from a single stock immediately while deferring taxes. For high-earners in California or New York, the marginal tax rates for long-term capital gains can exceed 35%, and short-term capital gains can exceed 50%. Considering the seven-year holding period, the tax alpha can be substantial for high earners. Use our Exchange Fund simulator to understand the potential impact on your wealth.

As we mentioned earlier, studies have shown that direct indexing produces a tax alpha of ~1% every year on average. Diversifying a single stock position relies on additional capital investment. Over a 10-year period, other research shows you can expect to generate 30% of the capital invested in tax losses. Higher tax losses are possible using more aggressive strategies like "Long-Short Direct Indexing" that use leverage to amplify the loss harvesting. 

Takeaway: The overall tax advantage from an exchange fund is substantial for high earners who hold significantly appreciated stock positions. Direct indexing generates harvestable losses, which can vary across market cycles, but averages to about 1% based on historical data.

So… exchange funds or direct indexing?

If you have a large stock position that you’d like to diversify, it is worth doing your due diligence on these options. Hopefully, our article sheds light on how you should be thinking about it. 

To summarize, here’s a quick rundown of everything we discussed:

Exchange funds are a passive investment vehicle designed to provide diversified exposure. They do not guarantee higher returns than their underlying stocks, and they are likely to fluctuate with market conditions. While exchange funds may be benchmarked against an index fund, it should also be noted that fund managers have limited ability to sell stock positions and rebalance the fund. Diversification reduces concentration risk, but it does not eliminate investment risk. It is still possible to lose principal when you participate in an exchange fund.

It’s our mission to make it easier for more investors to manage large stock positions, so we have many additional resources that may be of interest. Start with an Exchange Fund overview or get into the nitty gritty with our deep dive into Exchange Funds.

If you’d like to see whether you’re eligible for an exchange fund, our other strategies for managing large stock positions, or ask more detailed questions, we’d be happy to talk. Just tell us about your situation. 

Disclosure

<p class="blog_disclosures-text">Material presented in this article is gathered from sources that we believe to be reliable. We do not guarantee the accuracy of the information it contains. This article may not be a complete discussion of all material facts, and it is not intended to be the primary basis for your investment decisions. All content is for general informational purposes only and does not consider your individual circumstances, your financial situation, or your specific needs, nor does it present a personalized recommendation to you. It is not intended to provide legal, accounting, tax or investment advice. Investing involves risk, including the loss of principal.</p>

<p class="blog_disclosures-text">Exchange funds are a passive investment vehicle designed to provide diversified exposure. They do not guarantee higher returns than their underlying stocks, and they are likely to fluctuate with market conditions. While exchange funds may be designed to track an index fund or ETF, it should also be noted that fund managers have limited ability to sell stock positions and rebalance the fund. Diversification reduces concentration risk, but it does not eliminate investment risk completely. It is still possible to lose principal when you participate in an exchange fund.</p>

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