Direct Indexing vs. Exchange Funds for Concentrated Positions

You’ve likely faced a situation with clients approaching you with a dilemma: they have a large holding in a single stock, perhaps from years of company stock options, an inheritance, or a successful investment. They know the risks of having all their eggs in one basket, but they’re also concerned about the tax hit if they sell.

One solution your clients might hear about is exchange funds for concentrated positions. But while exchange funds can offer some benefits, they also come with limitations that may not meet your clients' needs. In many cases, Orion Custom Indexing provides a more flexible, customizable approach that better aligns with your clients’ financial goals.

I'd like to help you understand how to discuss the pros and cons of exchange funds with your clients and why Orion Custom Indexing may be a more compelling strategy for diversifying their concentrated positions.
 

Understanding Exchange Funds for Concentrated Positions

Exchange funds are often used by investors with concentrated stock positions looking to diversify without triggering immediate capital gains taxes. For example, consider a client who was an early employee at Microsoft and has a significant amount of company stock. Their goal is to diversify but without paying a large tax bill.

When they place their Microsoft stock into an exchange fund, they join other investors contributing different stocks. In return, they receive a diversified portfolio, which helps spread risk. This defers the capital gains taxes they would otherwise owe if they sold their shares outright.

Pros of Exchange Funds for Concentrated Positions:

• Tax Deferral: Exchange funds allow clients to defer capital gains taxes, which can be a big advantage.
• Instant Diversification: Your client moves from holding a single stock to owning a diversified basket of investments, which reduces risk.
• Reduces Idiosyncratic Risk: Exchange funds help mitigate company-specific risk for investors concerned about the impact of a company’s performance on their overall financial health.

Cons of Exchange Funds for Concentrated Positions:

• Lock-In Period: Exchange funds often require a holding period of up to 7 years, limiting your client’s ability to access their funds if their needs change.
• Lack of Customization: The investments in an exchange fund are managed by the fund itself, so your client has little control over the specific holdings in their portfolio.
• Subject to Approval: The manager running the strategy must first approve your stock inclusion; otherwise, the fund runs the risk of being full of a single company’s stock.
   

While exchange funds can work in some scenarios, the lack of flexibility and long lock-in period might diminish their appeal for clients who prefer a greater degree of control over their investments.

Why You Should Consider Orion Custom Indexing for Concentrated Positions

For investors seeking more flexibility, Orion Custom Indexing offers a different, more personalized way to manage concentrated stock positions. Instead of locking your client’s investments into a predefined fund, Orion Custom Indexing lets you gradually transition their concentrated holdings into a diversified portfolio, all while minimizing the tax impact.

Benefits of Orion Custom Indexing for Your Clients:

• Tax Transitioning Over Time: You can help your clients sell their concentrated positions gradually, spreading out the tax liability over several years and reducing the immediate hit from capital gains. It's a tailored way to diversify while managing taxes efficiently.
• Year-Round Tax-Loss Harvesting: Unlike exchange funds that offer a one-time tax deferral, Orion Custom Indexing provides continuous tax-loss harvesting opportunities. This means you can capture tax savings for your clients all year long, enhancing their overall return potential.
• Complete Customization: Create portfolios that better align with your client’s personal values and financial goals. Whether they want to avoid certain industries or focus on ESG (environmental, social, and governance) factors, you have the flexibility to build a portfolio that fits their unique needs.

This level of personalization and control makes Orion Custom Indexing an attractive option for clients who are serious about achieving their long-term financial goals.

When Exchange Funds for Concentrated Positions Might Still Be Useful

There are some situations where exchange funds might still be a viable option for your clients, even when Orion Custom Indexing seems to offer more flexibility.

• Clients Who Prefer Passive Management: If your client is looking for a more hands-off approach and is comfortable with a lack of control over the fund's specific holdings, an exchange fund might be suitable.
• Long Holding Periods: For clients who don’t need immediate liquidity and can commit to a 7-year lock-up, exchange funds can provide straightforward diversification without requiring active involvement.

However, for many high-net-worth clients looking for a more strategic and personalized approach to managing concentrated positions, Orion Custom Indexing may offer more significant benefits.

Empower Your Clients' Financial Future with Tailored Strategies

As a financial advisor, your goal is to guide your clients toward smarter financial decisions that align with their individual needs. While using exchange funds for concentrated positions can offer some advantages, they also come with notable drawbacks, like limited customization and long lock-up periods.

Orion Custom Indexing enables you to create tax-efficient, personalized strategies that help clients transition out of their concentrated positions on their own terms. With features like tax-loss harvesting and a high degree of portfolio customization, Orion Custom Indexing stands out as a, effective, more flexible solution for long-term diversification.