Exchange Funds can provide qualified investors with both diversification and potential tax-deferred growth.
Voice Over
One of the first things every investor learns is that diversification can help mitigate risk. As the saying goes, “Don’t put all your eggs in one basket.”
But the reality of investing is that despite your best efforts you may still find yourself with highly concentrated positions. Meaning too much of a single stock.
This can happen through an inheritance, a buildup of employee stock in an equity compensation plan or simply by holding assets that have grown over time.
Of course, it's possible to sell most of a concentrated position and diversify into other investments. But without the right planning, that could easily lead to a big capital gains tax bill.
Your Morgan Stanley Financial Advisor can help you, and other investors with the same issue, manage concentrated positions and re-diversify in a tax-efficient way by potentially taking advantage of exchange funds.
If you quality, an exchange fund lets you swap your concentrated shares in one security for the equivalent value of shares in a diversified fund.
Because this is not a taxable transaction for US federal income tax purposes, you can potentially defer capital gains taxes until you sell the fund shares down the road.
It’s part of our Total Tax 365 approach – which lets you incorporate a full range of tax-smart strategies into your investment planning, all year round.
Taken together, the solutions that make up Total Tax 365 may potentially add up to 2% to your annual returns, on average, depending on your specific portfolios and approaches.*
[on screen] * Source: Morgan Stanley Global Investment Committee Special Report: “Tax Efficiency: Getting to What You Need by Keeping More of What You Earn” Past performance is not a guarantee of future results. Intended results may not be achieved.
Let’s take a closer look at what it means to have a concentrated portfolio. A stock position is typically considered concentrated when it represents 10% to 20% or more of your portfolio value.
There are many ways investors end up with concentrated positions and many factors that inhibit investors from selling—including taxes, bullish expectations, psychological barriers, regulations or public perceptions.
But if you have an outsized position in your portfolio, you may be taking on outsized investment risks.
Let’s look at a recent example. Consider what happened to the S&P 500 Index in 2020. While the index finished the year up 18%, just five high-performing stocks – Apple, Amazon, Microsoft, Nvidia, and Meta – accounted for nearly half of the index’s return. In fact, over 24% of the stocks in the index were actually down by 10% or more by year end 2020.
[on screen: Source: Bloomberg and Factset. Past performance is not indicative of future results. It’s not possible to invest directly in an index.]
Even longer-term, the story is similar. Over the 25 years ended in 2021, the S&P 500 has only declined by more than 10% in three calendar years. By comparison, a quarter of the stocks in the index declined by more than 10% in each year on average.
[on screen: Source: Bloomberg and Factset. Past performance is not indicative of future results. It’s not possible to invest directly in an index.]
All said, the odds of a concentrated position being one of the underperformers in any given year, may be higher than you realize.
That’s where exchange funds come in. They allow qualified investors to move into a diversified fund in a tax-smart way.
Because you and other investors may run into the same issue, exchange funds are an aggregate of many investors’ concentrated stock -- enabling investors to exchange their concentrated shares for the equivalent value of shares in a diversified fund.
Since many Exchange Funds seek to track the performance of a broad index, like the S&P 500, despite some tracking error, you can gain exposure to hundreds of varied securities.
Let’s look at what tax-deferred growth can mean in the real world. Since taxes vary by state, let’s say you’re a California resident whose assets are all in Stock A.
Concerned about the increased risks of a concentrated portfolio, you sell $1 million worth of your stock A shares. Assuming a zero cost-basis and an effective tax of 37.1%, you would have $629,000 dollars left to invest in a diversified portfolio. That means you’d need a return of over 58.9% just to get back what you paid in taxes.
[on screen: Source: Eaton Vance Parametric Investment Tax Calculator. The output of this calculator is for educational purposes only and should not be considered investment, legal or tax advice. It is intended for use by U.S. individual taxpayer's resident in the 50 states or the District of Columbia and is not applicable to trusts, estates, corporations or persons subject to special rules under federal, state or local income tax laws. The indicated tax treatment of investment income and gains applies to positions in securities held outside qualified retirement plans and other tax-deferred or tax-exempt investment vehicles. The output is general in nature and is not intended to serve as the primary or sole basis for investment or tax planning decisions. Indicated tax rates are those in effect for 2022, as updated February 4, 2022. Indicated rates are those that apply to an incremental dollar of additional income or gain, which may vary from average tax rates. The displayed rates have been rounded to the nearest hundredth of a percent. The indicated Total Tax Rate may not add up to the displayed component rates due to rounding.
For illustrative purposes only and does not represent the performance of any specific investment or strategy. An investor’s actual performance will vary. Past performance is not a guarantee of future results.]
Swapping into an exchange fund, on the other hand, means you could invest the full million into a professionally managed, diversified fund.
Let’s see that in action--assuming an 8% annual growth rate over 20 years for both hypothetical portfolios.
For the “sell and buy” approach you pay taxes up front – but you sacrifice the power of investment exposure over time.
On the other hand, with the Exchange Fund you got to keep the full value of your investment power – but at the expense of a larger tax bill at the end.
However, when all is said and done, the “sell and buy” portfolio would be worth roughly 2 million dollars, while the exchange fund would be worth roughly 3 million dollars. That’s a big difference in final value on a post liquidation, after tax basis.
Exchange funds may not be for everyone. They’re designed for long-term, qualified investors. While many offer early redemptions, some may charge fees for early withdrawals, or they may have other liquidity constraints.
But all things considered, exchange funds can offer an efficient way to diversify holdings while benefiting from potential growth.
In practice, decisions like whether to realize gains today, defer recognizing them by continuing to hold your portfolio or consider an exchange fund strategy, are often more complex than they look. And their solutions—like all our Total Tax 365 strategies— work best when factoring in all your accounts and holdings.
Many of us keep accounts at different firms for different reasons. But if some of your assets are not visible, you may not reach full potential.
That’s why consolidation may itself be a tax-smart move. By bringing all your accounts together, we can take a holistic view of your portfolio, understand what changes could help you seek the most tax-efficient outcome.
With Total Tax 365, your Morgan Stanley Financial Advisor can help bring innovative technology to the old wisdom about eggs and baskets.
Diversification has typically played a key role in managing risk—and if you qualify, you can do it in a tax-smart way that’s integrated into your investment plan and financial goals.
Contact your Financial Advisor to see how Total Tax 365 can help.
Disclosure (on screen)
This material is not a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy. This material does not provide individually tailored investment advice. It has been prepared without regard to the individual financial circ*mstances and objectives of persons who receive it. Morgan Stanley Smith Barney LLC (“Morgan Stanley”) recommends that investors independently evaluate particular investments and strategies and encourages investors to seek the advice of a Morgan Stanley Financial Advisor. The appropriateness of a particular investment or strategy will depend on an investor’s individual circ*mstances and objectives.
Morgan Stanley, its affiliates and Morgan Stanley Financial Advisors and Private Wealth Advisors do not provide tax or legal advice. Clients should consult their tax advisor for matters involving taxation and tax planning and their attorney for matters involving trust and estate planning, charitable giving, philanthropic planning and other legal matters. Including any implementation of any strategies or investments described herein.
Asset allocation, diversification and rebalancing do not assure a profit or protect against loss. There may be a potential tax implication with a rebalancing strategy. Please consult your tax advisor before implementing such a strategy.
Exchange funds are private placement vehicles that enable holders of concentrated single-stock positions to exchange those stocks for a diversified portfolio. Investors may benefit from greater diversification by exchanging a concentrated stock position for fund shares without triggering a taxable event. These funds are available only to qualified investors and may only be offered by Financial Advisors who are qualified to sell alternative investments.
• Before investing, investors should consider the following: • Dividends are pooled • Investors may forfeit their stock voting rights • Investment may be illiquid for several years • Investments may be leveraged or contain derivatives • Significant early redemption fees may apply • Changes to the U.S. tax code, which could be retroactive (potentially disallowing the favorable tax treatment of exchange funds) • Investment risk and potential loss of principal
Certain strategies managed or sub-advised by us or our affiliates, including but not limited to Morgan Stanley Investment Management (“MSIM”), Eaton Vance Management (“EVM”), Parametric Portfolio Associates® LLC (“Parametric”), and its investment affiliates, may be included in your account. Please contact your Morgan Stanley team and/or see the applicable Form ADV, which can be accessed at www.morganstanley.com/adv for more information about additional disclosures applicable to affiliated products that could be included in your account.
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