The Exchange Fund Swap Mistake
Tried, True and Tested from the 1700's
Recently I was talking to a former coworker and he mentioned how popular Exchange Fund Swaps are with his high networth clients. Exchange Funds are catered to people with highly concentrated positions of stock that was purchased at a low dollar cost and now is at a high dollar amount. Recent stock examples can be seen with early buyers of Tesla, Facebook/Meta, and Apple to name a few. As we talked more,
a few questions popped into my head on why anybody would want to do a swap from a concentrated position to another portfolio with a 7 year minimum time frame and risk.
To manage risk, a simple strategy is to sell a portion of the position or out right sell the entire position which creates a capital gain. But, they don’t need the money so long term holding becomes a strategy to defer a capital gain.
Another method to manage the position risk is to use option contracts. The options markets are tried, true, tested going back to the 1700's in Amsterdam. From farmers, insurance companies, to hedgers; options have been used by many players for hundreds of years to manage risk. Various option strategies can be used to manage the downside risk. A few examples:
1. Buy a bunch of put contracts into the future and lock in any downside risk. This can be done with a portion of the portfolio or the entire amount.
2. Limit your upside gain but lower your cost for the hedge by buying puts and selling calls to net your hedge cost basis lower.
The benefits of this is the flexibility and instant liquidity you have versus being locked up for 7 years. Both have fees involved, so that’s a nonissue.
Call me old fashion but insurance companies do this often on their products when you see some type of managed volatility instead of using an Exchange Fund Swap.
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