Because investors usually receive individual securities when they leave an exchange fund, they need to pay close attention to the fund's overall composition, says Curtis Krietzberg of Sagemark Consulting in Iselin, N.J., a member of Lincoln Financial Advisors. "Because of the long-term nature and redemption features of most exchange funds, investors need to carefully review and understand the stocks in a fund's portfolio, since they may own them for quite some time."

Despite their benefits, exchange funds are not suitable for every investor with a concentrated stock position, cautions Flood. "While exchange funds provide diversification, they don't protect investors against broad market declines. This ongoing market exposure is one reason some risk-averse investors may be better off selling their shares outright or hedging them with options, depending on their situation."

Hanahan agrees. "Exchange funds can be a valuable diversification tool for investors with a longer-term focus, but they aren't appropriate for someone looking for a way to protect their holdings from short- or intermediate-term losses." Exchange funds also are a poor choice for investors who rely on dividend income, he adds, since most exchange funds reinvest dividends in the fund.

Exchange funds have other drawbacks as well. For example, liquidity can be a problem. Investors are often required to remain in the fund for at least seven years before redeeming their shares. And investors who leave prematurely can face heavy penalties and often only receive their original shares back, rather than a diversified basket of stocks. This liquidity problem is compounded by the fact exchange funds do not trade on secondary markets, and often limit investors to monthly or even quarterly redemptions. "The lack of liquidity is a primary reason we emphasize to our clients that using exchange funds is a long-term investment strategy," Flood explains.

Also, while investors who sell their stock outright retain control over their funds, the same isn't true for exchange fund investors. "You really need to be comfortable with the exchange fund manager and the fund's focus before investing," says Krietzberg. "Not all funds are properly diversified or compatible with a client's overall investment strategy." In contrast, an investor who sells his shares or borrows against a derivative position can use the proceeds to invest in stocks that may better fit his long-term investment goals.

Exchange funds can also be expensive, adds Hanahan. Most funds charge an initial placement fee of 1% to 2% of the contributed share's value, plus an annual management fee of around 1% of fund assets. A few funds also charge additional fees when investors leave the fund. "Investors need to take these expenses into account when deciding whether an exchange fund is the best way for them to deal with a concentrated stock position," says Hanahan. They also need to factor in the fund's start-up and other organizational expenses, which are normally allocated to shareholders, adds Tagg.

"Before investing in an exchange fund, shareholders also need to understand these funds are a tax-deferral strategy, not a way to eliminate taxes altogether," says Flood. When an investor leaves a fund and receives a basket of individual stocks, these stocks retain the aggregate basis of the investor's original stock contribution, Flood explains. As a result, an investor can still incur significant capital gains tax liability if he decides to sell these distributed shares.

For example, say an investor contributes 50,000 Intel (INTC) shares to an exchange fund with an aggregate basis of $500,000. When he leaves the fund, he will receive a basket of several different stocks, but the aggregate basis of these stocks will still be $500,000-the basis of his original contribution. This is true regardless of the current market value of the distributed shares.

There also is the possibility that lawmakers might amend the tax code to further restrict, or even eliminate, exchange funds. While Flood discusses this possibility with his firm's clients, he does not believe any changes are imminent. "While anything is possible with the government, lawmakers have been talking about curtailing or eliminating exchange funds for years without taking any real action."

And even if Congress did eliminate exchange funds, Flood believes investors would likely have their original shares returned to them without any penalties. "While this would defeat the purpose of participating in the fund, it would not necessarily put the investor in any worse position than when they made their initial contribution."