Exchange Funds vs 351 ETF Conversions: Key Differences for Investors

‍Exchange funds help investors reduce their concentration risk and could be a fit for investors who hold a substantial portion of their net worth in one or two stocks. Investors pool their concentrated stock positions into a fund carefully weighted towards an investment objective, and each investor is diversified by participation.

On the other hand, a Section 351 ETF conversion lets you transform your diversified stock portfolio into exchange-traded fund (ETF) shares without triggering capital gains taxes. For investors with large stock portfolios who want professional management but have been hesitant due to the tax consequences of rebalancing, this strategy may be a solution. You diversify your exposure further while gaining the benefits of an ETF - professional oversight, easier trading, and deferral - without the tax bill that usually comes with portfolio restructuring.

Is a 351 exchange a good tool for reducing concentration risk? That's not what it's designed for. To qualify for a 351 exchange, your portfolio already needs to be well diversified. No single stock can make up more than 25% of your contribution, and all positions over 5% must collectively represent no more than 50% of the portfolio. In short, you’ll need a large, diversified stock basket beyond your concentrated holdings that you’re willing to commit to the exchange transaction. If you’re heavily concentrated, you’ll likely need to address that before considering a 351 exchange.

Core purpose and use cases 

Beyond their tax advantages, exchange funds and 351 ETF conversions target distinctly different investment challenges. Understanding which tool matches your situation can save you significant time and costs in restructuring your portfolio.

Exchange funds

Exchange funds solve one specific problem: helping you diversify from concentrated stock positions without triggering an immediate capital gains tax bill. These funds transform single-stock risk into broad market exposure by pooling your shares with other investors' concentrated positions. They often work best for corporate employees with large single-stock positions, venture investors with concentrated holdings from IPOs, and investors who made the right bets.

Take this common scenario: You're a tech executive who joined your company six years ago. Your equity compensation has grown into a $4 million position with a $400,000 cost basis - now representing 50% of your net worth. The stock has performed well, but having so much of your wealth tied to one company's performance keeps you up at night. 

Through an exchange fund, you contribute your shares alongside other investors facing the same challenge. Each investor is instantly diversified. After a seven-year holding period, you can redeem a diversified basket worth your ownership in the fund. This structure suits patient stock market investors with a long-term investment horizon who don’t have immediate liquidity needs.

See how it works with this exchange fund calculator.

351 ETF conversions

The fundamental purpose of converting to a 351 ETF is different: It is designed to smoothly transition a diversified portfolio in-kind to the ETF wrapper, which offers operations, cost benefits, and ideally improved investment selection. This solution particularly fits investors with diversified portfolios (like an SMA structure) that have become tax-inefficient due to embedded gains, limiting opportunities for tax-loss harvesting.

A 351 conversion could come into play for an investor who has successfully pursued a diversified strategy for several years. To be a candidate, no single position can make up more than 25% of the assets they plan to contribute to the fund, and positions over 5% cannot make up more than 50%. If your portfolio is spread across dozens of companies or highly appreciated ETFs you’d like to diversify away from, you might be a candidate. 

The fund manager gathers investors in similar situations to pool their diversified portfolios into a new ETF. The intent is for each investor to be much more broadly diversified than where they started from. You'll get ETF shares equal to your contribution without any taxable events. Your cost basis and holding period carry over to your new ETF shares. 

It isn't a magic solution for a too-many-eggs-in-one-basket situation. Still, it is a tax-efficient next step for those who have maintained a diversified portfolio and want to take advantage of the ETF wrapper.

Portfolio requirements

One of the most considerable differences between exchange funds and 351 ETF conversions is what you can contribute to each vehicle.

Here's a quick comparison table of the portfolio requirements:

Liquidity and investment structure between exchange funds and 351 exchanges

Both Exchange Funds and 351 ETF conversions offer paths to diversification, but their liquidity profiles and investment structures create distinctly different experiences for investors.

Exchange fund dynamics

Exchange Funds operate as private placements under a partnership structure. You'll face three key liquidity constraints:

• A 7-year holding period to redeem a diversified portfolio
• Earlier redemptions can only be satisfied with stocks that the investor has contributed
• No public liquidity – monthly redemption with fund manager subject to limitations

The investment structure also follows certain guidelines like:

• 20% of assets held in qualifying investments like real estate
• Limited rebalancing capabilities due to tax implications
• Passive management approach with minimal trading activity

351 ETF conversion framework

On the other hand, 351 ETF conversions provide liquidity through exchange-traded shares. Your position benefits from:

• Immediate liquidity upon ETF launch
• Standard exchange-based trading through any broker
• No lockup periods or redemption restrictions

The registered investment company (RIC) structure also offers:

• Internal rebalancing without triggering taxable events
• Flexibility to implement active or passive strategies
• Standardized ETF creation/redemption mechanisms

Where it could make sense to consider using both an exchange fund and 351 conversion to ETF

These are NOT competing solutions; you may find a case where it makes sense to use both. 

For example, if someone has 50% of the net worth in a single name and 50% in an SMA with limited potential for tax efficiency, it could make sense to 351 the diversified portfolio PLUS some of the concentrated position and do the rest of the concentrated position in the exchange fund.* 

Comparison table of key features

Exchange Fund

351 Conversion to ETF

Use Case

Diversify a concentrated position

Reduce operating costs and diversify a "locked up" portfolio

Ideal case

E.g., Shares vested at $350,000 and are now worth $1,000,000

SMA is “locked up” with limited tax-loss harvesting opportunities

Investment Lifecycle

1. Contribute concentrated position

2. Fund managers assemble a diversified portfolio (including non-securities to meet investment qualification requirements)

3. Wait 7 years

4. Withdraw a diversified partnership stake without gain recognition

5. Cost basis is the same as contributed assets 6. Sell diversified assets and realize gain (or hold until basis step-up)

1. Seed ETF with a diversified SMA portfolio in exchange for ETF shares

2. ETF begins trading on an exchange

3. ETF coordinates with authorized participants to handle in-kind redemptions and portfolio rebalancing

4. Cost basis is the same as contributed assets

5. Sell ETF shares and realize gain (or hold until basis step-up)

Contribution Diversification Requirements

Rule of thumb: "Concentrated to diversified." Typically, investors contribute single-stock positions with a low-cost basis

Rule of thumb: "Diversified to diversified." Investors must contribute a diversified portfolio to avoid gain recognition

Vehicle

Limited partnership

Entity meeting
Registered Investment Company requirements

Minimum

$100,000

$1,000,000

Investor status

Typically qualified purchasers. Recently, accredited investors

General public typically

Cost

0.40% - 1.50% (depends on product and manager)

0.459% - 1.50% (depends on product and manager)

Diversification Timeline

Near-term: As soon as the fund closes

Near-term: On first trading day

Cost Basis, Holding Period

The original cost basis and holding period of the contributed assets carry over to the investor's interest in the fund

The original cost basis and holding period of the converted assets carry over to ETF shares received

Seed Window

Several months to assemble an initial portfolio, Bi-weekly to semi-annual close post initial seeding

2-3 months before Investment creation

Investment Selection

Typically large equity indices: S&P 500, Russell 1000, Russell 3000, NASDAQ 100

Any SEC-approved strategy accepting 351 conversions for seeding Tends to be active strategies w/ broad mandates to accept a variety of assets

Post-transaction portfolio

80% diversified contributions from partners, 20% illiquid assets (usually real estate)

Diversified basket of securities tracking the investment objective of the ETF>

Liquidity

7-Year Rule: Investors typically hold for 7 years to withdraw diversified shares without gain recognition

Immediate: ETF shares can be traded on the exchange upon launch

Emergency access

Withdraw contribution before seven years for a 1% - 2% penalty

Sell shares

Bequeath - before 7 years

Step-up in basis

Step-up in basis

Bequeath - after 7 years

Step-up in basis

Step-up in basis

Permanently Avoids Tax

No. Except in step-up in basis

No. Except in step-up in basis

Withdraw basis

Yes, possible if fund manager supports

No

In collaboration with

Finding your path forward

Exchange funds and 351 ETF conversions both help you diversify, but they shine in different scenarios.

Exchange funds are better for immediately diversifying a large single-stock position. You contribute your shares and wait (typically 7 years) to receive a diversified portfolio in return.

351 ETF conversions work best when you already have multiple appreciated stock positions and want to quickly convert them into a diversified ETF portfolio in a single transaction.

Ultimately, the right choice depends on your unique portfolio, timeline, and liquidity needs. Consult your advisors to find the approach that best aligns with your wealth management goals — or take a closer look at the Cache Exchange Fund to see how it can help.

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<div class="blog_disclosures-text text-weight-semibold">This communication is not an offer or solicitation of securities and is intended to inform only. Any product discussed within should only be purchased after the client reviews the offering documents and executes a subscription agreement.  This product is not appropriate for all investors, and Cache has not considered the actual or desired investment objectives or goals of any individual investor.  Before investing investors should carefully consider the risks associated with the investment and make their determination if the investment is consistent with their investment objectives and risk tolerance. Cache does not make investment recommendations. Investing involves risk. While diversification may help spread risk, it does not assure a profit or protect against loss, and investing could result in a loss of your entire existing principal when you invest in securities.  Exchange Funds defer taxation on investments; however, they do not eliminate the need to pay taxes on the sale of assets. Furthermore, to realize the benefits of tax deferral, you need to abide by the restrictions specified in your offering document.  Please consult your tax advisor for information specific to your situation.</div>

<div class="blog_disclosures-text text-weight-semibold">Exchange Funds are offered to Accredited Investors and Qualified purchasers only. Accredited Investor- In the US, individuals can qualify if they have an annual income exceeding $200,000 individually or $300,000 jointly with a spouse for the past two years and expect the same amount in the current year. Alternatively, individuals can also qualify by having a net worth greater than $1 million, either individually or jointly with a spouse, excluding the value of their primary residence.</div>

<div class="blog_disclosures-text text-weight-semibold">A Qualified Purchaser status requires individuals to comply with certain financial thresholds associated with their investments. Specifically, an individual becomes a Qualified Purchaser when they hold at least $5 million in investments. Companies, investment managers, or other types of organizations may also fit this category if they have investments valued at $25 million or more.</div>