I have spent the last several months battling misconceptions about the application and structure of 351 ETF exchanges with RIAs, broker-dealers and custodians in preparation for the launch of our hedged large-cap ETF on June 15. A 351 ETF exchange can be a great way to change a qualified client’s allocation without an immediate tax hit, provided the investor follows a few straightforward rules. 


1. The exchange fund confusion


Let’s start with the big one: People confuse 351 ETF exchanges with exchange funds. They may both come up in concentrated stock conversations, but they can solve different problems in unique ways.

An exchange fund is a private investment vehicle for single concentrated positions, which usually have higher fees, limited transparency, a seven-year lockup, 20% in illiquid assets and restricted liquidity even after the lockup is done.

A 351 ETF exchange transfers highly appreciated stocks or ETFs into the first day of a new ETF while deferring taxes. It offers all the benefits that people love about ETFs: generally lower fees, transparency, liquidity, and flexibility, provided it meets the diversification requirements. Unlike the 351 Exchange Fund, to comply with Section 351 ETF Exchange requirements, contributed securities must align with the investment strategy outlined in the new ETF’s prospectus. This ensures that the initial holdings which form the fund’s actual portfolio are managed in accordance with the ETF’s mandate immediately upon contribution. 


2. Misinterpreting the 25/50 diversification rule


The 25/50 diversification rule is another place people get tripped up. It is a straightforward requirement that the top issuer security must not exceed 25% of the contributed portfolio and the top five positions cannot exceed 50%. If contributing an equal weight of stocks, an investor would need a minimum of 11 stocks.

However, there is a look-through on ETFs. If an investor was only contributing a single S&P 500 ETF, it would count as 500 positions and meet the requirement. It is important to remember the diversification test is done per client account, not on the aggregate contributions.
 

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3. Basis step-up vs. tax deferral


Another misconception is that the cost basis resets. This is an opportunity for an investor to change an allocation without an immediate tax hit, but it does not step up the taxes. It carries the cost basis and duration of the contributed positions.

A 351 ETF exchange is generally about deferring recognition of gains while changing an allocation, not erasing them. Taxes may be deferred while the client transitions a concentrated position into a more diversified structure and potentially even further mitigating risk by allowing a change in strategy. That can make a meaningful difference.


4. Clarifying cost basis


Cost basis is another area where people often need clarification. Advisors sometimes assume the investor ends up with one neat, averaged basis in the new ETF position. Not necessarily. In many cases, the new ETF shares received can carry multiple cost basis mapped over from the positions contributed. That may sound annoying, but it is not unusual in wealth management. Advisors already deal with tax lots, legacy positions and all kinds of basis-specific planning.


5. Overcoming operational hurdles


And that brings me to the final misconception: that 351 ETF exchanges are somehow too onerous. The operational lift may be lighter than expected. Yes, it requires coordination. Yes, clients need clear expectations. But if the outcome is a more diversified, more behaviorally durable investment allocation, that work may be well worth it. After all, the target is not just reducing single-stock risk on paper. It is helping clients stay invested in a structure that better supports long-term financial decision-making. That is very much in line with the Behavioral Portfolio mindset and Toews’ broader focus on risk-aware equity exposure designed to support investor wellbeing.


And that is why this conversation matters right now.

If you are thinking about concentrated stock solutions, tax-aware transitions, or what a hedged equity allocation can look like on the other side of this process, reach out. We would be glad to talk. 


As Toews approaches the June 15 launch of our hedged large-cap ETF, these conversations are more relevant than ever. For investors managing concentrated positions and seeking a transition to a more resilient, downside-aware equity allocation, the Section 351 ETF exchange remains a sophisticated, underutilized option to consider.


Contact Eben Burr HERE. 
Instantly Download the 351 ETF Exchange FAQ HERE.
 

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ABOUT THE AUTHOR

Eben Burr is the President of Toews where he helps oversee the culture and direction of the firm which specializes in creating strategies designed with the clients financial and emotional wellbeing in mind. Eben has worked in various capacities at Toews since 2009 and before that in real estate in New York City. Eben advocates bringing behavioral psychology, introspection, and empathy into portfolio construction, planning, and communication.  He has a BA in history, studied architecture in Paris, has a master’s degree from Pratt in New York and now lives in Manhattan with his wife, son, and lots of guitars.

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