Successful business owners and corporate executives often share a similar problem-a large part of their wealth may be tied up in a single company's stock. After weathering the recent bear market and corporate scandals, most of them realize the risks involved in holding such highly concentrated positions. Nevertheless, many are unwilling or unable to sell their shares, generally because they are either restricted or have such a low cost basis that selling them would result in huge capital gains taxes.

Financial advisors use several strategies to help clients in this situation. Some of these, like equity collars and prepaid variable forward contracts, involve hedging the client's stock position to limit potential losses. Other strategies focus on splitting up the concentrated position to create a diversified stock portfolio. This latter category includes exchange funds, an often-overlooked way to provide client's immediate diversification without selling stock or incurring tax liability.

Exchange funds are private placement limited partnerships or LLCs specifically designed for investors with concentrated positions in highly appreciated or restricted stock. These funds have been around in one form or another for decades, yet with the exception of a brief stint in the spotlight during the late '90s, they continue to go largely unnoticed by many investors and advisors.

Here's how exchange funds work. A financial institution, usually a large bank or investment company, establishes a fund and opens it for contributions. Investors with concentrated stock positions then transfer some of their shares to the fund, which are pooled together to create a diversified portfolio. Once the fund reaches its target size and portfolio composition it closes, and each investor receives an ownership interest in the new fund in proportion to the value of their original contribution.

Exchange funds come with a twist, though. Unlike most stock transactions, the transfer of stock to an exchange fund does not trigger any capital gains tax liability. Instead, these transfers are considered nontaxable partnership contributions under Internal Revenue Code section 721. Although this section ordinarily does not apply to contributions of stocks or other securities, an exception exists for funds meeting certain criteria.

For example, an exchange fund can only hold 80% of its assets in stocks or other readily marketable securities. The remaining 20% must be held in illiquid investments. Exchange funds often satisfy this requirement by purchasing operating units in specialized real estate partnerships. Some funds use leverage to purchase these units, while others require investors to contribute cash in addition to their stock. And while these illiquid investments can act as a drag on returns during bull markets, they provide added diversification and stability during rough times.

Several financial firms offer exchange funds, including Eaton Vance, Goldman Sachs, Merrill Lynch and J.P. Morgan. While these funds share similar structures, they differ in size, composition and investment objectives. "Some funds, like Eaton Vance's Belterra Fund, focus on building a portfolio of well-known large-cap stocks, while others like Merrill Lynch's Montvale Fund lean more toward the mid-cap market." says Blake Flood, vice-president of investments at Atlanta-based Consolidated Planning Corp., an affiliate of Raymond James Financial Services. "Other funds try to track major stock indices such as the Standard & Poor's 500 or the Nasdaq 100.

Specific decisions about which stocks to include in a fund are ordinarily left to the fund manager's discretion. "The fund manager can reject shares in companies that do not fit the fund's criteria for market capitalization, industry sector, profitability or any number of other factors," explains John Hanahan, president of Yukon Capital Management in Overland Park, Kan. And while this can make it difficult for shareholders in small or newly established companies to find a suitable exchange fund, it helps the fund manager maintain a balanced, high-quality portfolio in line with his investment philosophy.

Like hedge funds and other unregistered securities, exchange funds are generally only open to "qualified investors" with a liquid net worth of at least $5 million and, in many cases, an annual income of $200,000 or more for the past two years. Most exchange funds also require a minimum investment of $1 million in stock, although a few require substantially more.

When investors leave an exchange fund they do not receive a cash distribution. Instead, they get a basket of individual stocks. "Depending on the fund, this distribution may consist of a pro rata share of all stocks held by the fund, or only a handful of specific fund holdings," says Richard Tagg, vice president of Charles Schwab & Co.'s strategic trading group in San Francisco. Like the investor's original stock contribution, this closing distribution is a nontaxable event. It's only when these distributed shares are actually sold that the investor must recognize a capital gain or loss.