Tech Insiders Turn to Exchange Funds to Reduce Single-Stock Exposure

Surging valuations across the technology sector are expanding the fortunes of founders, senior executives and long-tenured employees whose compensation is heavily concentrated in company stock. Financial advisors say that concentration brings significant risk, prompting many high-net-worth individuals to move shares into exchange funds as a way to diversify without incurring immediate capital-gains taxes.

An exchange fund—also called a swap fund—allows participants to contribute shares of a publicly traded company in return for a partnership interest in a diversified pool of equities. After a mandatory lock-up period, typically seven years, investors can redeem that interest for a basket of stocks that mirrors broad market indexes, thereby reducing their single-stock exposure while deferring taxes on unrealized gains.

Rob Romano, head of capital markets investor solutions at Merrill, said clients who hold a large stake in one company face both the “biggest risk and biggest opportunity.” Many wealth managers use a guideline suggesting no more than 10% of a portfolio should rest in any one security. With the S&P 500 near record highs and artificial-intelligence optimism lifting tech valuations, more individuals exceed that threshold, particularly in Silicon Valley and other technology hubs.

Exchange funds have existed since the 1970s but are drawing renewed interest as equity compensation expands. Eric Freedman, chief investment officer for Northern Trust’s wealth management unit, noted that established tech companies are boosting stock grants to compete with venture-backed AI start-ups, further increasing employees’ exposure to a single ticker.

How the structure works

Under Internal Revenue Service rules, at least 80% of an exchange fund’s assets must be invested in marketable securities, while the remaining 20% must be held in non-security assets. Real estate is the most common choice for the non-security portion. By contributing appreciated shares to the partnership, an investor defers recognizing capital gains until redeeming the diversified basket, at which point the cost basis carries over.

The model accepts only accredited investors—individuals with a net worth above $1 million excluding primary residence or annual income above $200,000 in each of the past two calendar years. Participants usually place only a portion of their holdings into a fund, preserving some direct exposure to their employer’s stock while “taking chips off the table,” according to advisors.

Potential benefits and limitations

Steve Edwards, senior investment strategist in Morgan Stanley’s wealth division, said clients increasingly view exchange funds as a way to manage legacy planning. Spreading risk across hundreds of companies narrows the range of potential outcomes for heirs, he explained. Without diversification, a sudden decline in a single high-flier could erase decades of paper gains.

Nonetheless, Edwards and others acknowledge behavioral hurdles. Long-time insiders often attribute their wealth to one stock and assume outperformance will continue. Historical research indicates that companies that have dramatically outpaced the market are more likely to lag in subsequent periods, but convincing shareholders to hedge remains challenging.

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Exchange funds also carry important caveats. The seven-year lock-up is inflexible: redeeming early generally voids tax deferral and triggers fees. In most cases, an early redemption returns the original contributed shares, limited to the value of the investor’s stake at that time. Liquidity needs during the lock-up must therefore be met through other means.

Scott Welch, chief investment officer at multi-family office Certuity, advises some clients to avoid exchange funds because of that illiquidity. He cites alternative de-risking strategies such as option collars, variable prepaid forward contracts, or tax-loss harvesting that pairs long and short positions. For clients focused on liquidity rather than diversification, borrowing against concentrated stock positions can be effective, he added.

Despite these concerns, interest in exchange funds is climbing alongside technology share prices. Fund sponsors increasingly design portfolios to track familiar benchmarks like the S&P 500 or the Russell 3000, helping participants gauge how their diversified basket may perform relative to the broader market.

Because exchange funds are typically structured as private partnerships, minimum commitments can reach several million dollars, and management fees vary by provider. Advisors stress the importance of scrutinizing fee schedules, diversification methodology and non-security holdings before subscribing. Proper due diligence can prevent surprises during the multi-year lock-up period and ensure the final basket aligns with an investor’s objectives.

For now, the primary appeal remains tax deferral combined with risk reduction. As technology valuations continue to inflate household net worth, more executives are seeking ways to protect those gains without liquidating core holdings. Exchange funds offer one path, though not the only one, for managing the delicate balance between concentration and diversification.

Crédito da imagem: Yuichiro Chino | Moment | Getty Images