Once someone realizes they have too much money in one stock, the next sentence is almost always the same: "...but I don't want to pay the taxes." Fair. If you're sitting on a position that's up 5x or 10x, selling means realizing a very large gain, and the tax bill is real money.
So an entire industry exists to answer that sentence, and two tools come up constantly: exchange funds and direct indexing. They get pitched side by side, sometimes interchangeably, and they are not remotely the same thing. One defers your gain by locking your money up for seven years. The other doesn't defer your gain at all — it manufactures losses to offset it as you sell over time. Let's take them one at a time.
Exchange funds: pooling your problem with everyone else's
An exchange fund is a partnership. You contribute your appreciated stock, a few hundred other people contribute theirs, and everybody walks away owning a slice of the pooled basket instead of their single name. Because of Section 721 of the tax code, contributing appreciated property to a partnership isn't a taxable event. You just diversified without selling.
Sounds great. Here's what it costs you:
- Seven years of your life. The tax rules effectively require you to stay in for seven years. Leave early and you generally just get your own stock back — no diversification, and you paid fees for the privilege. A good walkthrough of the mechanics is on Kitces.com.
- A weird 20 percent. To qualify for the tax treatment, the fund can't be more than 80 percent securities — so these funds hold at least 20 percent in illiquid assets, usually real estate, often bought with borrowed money. You're not just buying diversification; you're buying a levered real estate sleeve you didn't ask for.
- The basket is what it is. Exchange funds attract people whose stocks ran the most — which lately means they can look a lot like a tech fund. If you work in tech, check what you'd actually be diversifying into.
- Deferral, not elimination. When you exit after seven years, you receive a basket of stocks with your old low basis carried over. The gain didn't disappear. It moved.
Direct indexing: selling anyway, with a tax engine attached
Direct indexing takes the opposite approach. Instead of owning an index fund, you own the individual stocks in the index — a few hundred separate positions in your own account. Software then harvests losses continuously: any position that dips gets sold, replaced with a similar-but-not-identical stock (to stay clear of the wash sale rule), and the realized loss goes in your pocket for tax purposes.
Why does that matter for a concentrated position? Because capital losses offset capital gains. Every dollar of harvested loss is a dollar of your company stock gain you can realize without tax. The strategy: fund a direct-indexing account (with cash proceeds, or other assets), let it generate losses, and use those losses to sell down the concentrated position faster than you otherwise could.
How much does the engine actually produce? The best academic look at this — Chaudhuri, Burnham, and Lo, studying 1926 through 2018 — found tax-loss harvesting added about 1.10 percent per year in tax alpha, dropping to roughly 0.85 percent once wash-sale constraints are respected. Meaningful, not miraculous. And front-loaded: fresh accounts harvest a lot, but after a few years of markets rising, most positions sit above basis and the losses dry up.
Side by side
| Exchange fund | Direct indexing | |
|---|---|---|
| What happens to your gain | Deferred — carries into the fund and back out | Realized on your schedule, offset by harvested losses |
| Liquidity | Effectively locked ~7 years | Daily — it's your account |
| Diversification | Immediate, into the pooled basket | Gradual, as you sell down the position |
| Complexity you inherit | Partnership K-1s, real estate sleeve, fund fees | Hundreds of positions, hundreds of 1099-B lines, management fee |
| Best fit | Very large, very low-basis, decade-plus horizon | Anyone selling down a position over several years |
The part nobody puts in the brochure
Both tools share a failure mode: they can become a way to avoid the decision instead of making it. I've seen people tour exchange funds for six months while their position stayed at 70 percent of net worth the whole time. The tax on selling is a known, bounded cost. The risk of staying concentrated is unknown and unbounded. Sometimes — more often than the wealth management industry likes to admit — the right move is to just sell, pay the long-term capital gains, and be done.
My honest ordering for most people: first, the simple things — long-term lots, spreading sales across tax years, charitable gifts of appreciated shares if you give anyway. Then direct indexing if you're selling down over years and the math on fees works. Exchange funds last, for the specific person they actually fit.
If you want to see what each path looks like with your real numbers — your basis, your bracket, your timeline — that's a modeling exercise, not a guess. It's exactly what I build in the diagnostic. Happy to run it with you.
Sources
- 26 U.S. Code §721 — Nonrecognition of gain or loss on contribution — the statute exchange funds are built on
- Kitces.com — When To Use Exchange Funds To Diversify Concentrated Holdings — mechanics, the 7-year lockup, the 20% illiquid-asset requirement, and the honest drawbacks
- Chaudhuri, Burnham & Lo, "An Empirical Evaluation of Tax-Loss Harvesting Alpha" (2020) — roughly 1.10% per year of tax alpha, 1926–2018; ~0.85% after wash-sale constraints
- IRS Publication 550 — Investment Income and Expenses — the wash sale rule that constrains loss harvesting
- IRS Topic 409 — Capital Gains and Losses — how realized gains and losses actually net against each other
This article is for informational and educational purposes only and is not investment, legal, or tax advice. Nothing here is a recommendation for your specific situation — talk to your advisor and your CPA before acting on anything you read. Fathom Wealth is the private wealth practice of Cameron Hunt, conducted through Savvy Advisors, Inc., an SEC-registered investment adviser. Tax figures cited reflect rules in effect for the year noted and can change.