Gus: We met in the early mid-'90s and pretty quickly struck up a friendship. Erik is probably one of the wittiest people I've ever met that's not, you know, from the UK.
(fun music underlay starts)
Gus: We had a fun night at a piano bar once. They had this nice, big sign saying, "No singing." You know, of course, what does Erik do? 'Cause this is the kind of guy he is. He gets the mic.
Erik: I got permission.
(laughs, fade out)
Jamie: Meet Gus and Erik. They sound like close friends, which they are, but you're also listening in on a conversation between a client and his financial advisor
Erik: Gus and I spend a lot of time together on the phone discussing all matters of the family.
Jamie: Gus plays an important role in his family. His grandmother, Colette, was a very successful real estate entrepreneur. She sold the business, creating considerable wealth for her family. And as part of the sale, she received a very large stock position. It made up about sixty percent of the family's fortune. When she was ready to step back from managing the investments and assets, she asked Gus to take over the role of managing the family office, which is like a private boutique firm established by a wealthy family to manage all its finances. At its core, the main mission is simple: grow the fortune, the legacy, and make sure that the wealth smoothly transitions to the next generation.
Gus: It's definitely a blessing and a, a challenge. When great wealth is created, in the family, it's 90% of the time lost by the third generation. And it's not poor investing, it's not divorces. It's usually poor preparedness of the heirs. You want the wealth to enhance the life of your family members. But, wealth is like medicine. A little bit can be great and too much can be deadly. And, what you're trying to do is make sure you don't become part of the 10% that loses the wealth by the fourth generation.
Jamie: And while Gus has serious financial acumen, he turned to Erik, a friend and a Morgan Stanley family wealth advisor, for help.
Gus: Erik has been my key thought partner for 24 years. We go to New York together once a year. We do a couple days of meetings with other people, and the meetings are phenomenal. But one thing that I really prize more than anything is just the time he and I get to spend walking the park and just talking things out. And we've been in meetings where there's a third party trying to sell us something, and Erik's not gonna let you know, any shenanigans go on. pulled me out of rooms before because he's like "This is garbage. We're leaving." It's that kind of trust and relationship, where I know he's got the best intentions for me and the family.
Jamie: Thanks to the financial plan Gus and Erik set up early on, the family is in a good place. Assets have nearly tripled in value, and they've de-risked their portfolio, diversifying that concentrated stock position. Today, Erik and Gus will take us through the strategy behind those wins, and what they need to do next to be tax efficient and evolve their investment plan. And that's where we'll start today. I'm Jamie Roô. Welcome to What Should I Do With My Money?, an original podcast from Morgan Stanley.
Here's Gus and Erik.
Erik: Gus, uh, before we start talking about all the things that we are about to do next, this is probably the perfect time to take a step back and review how we got here. So, if we go back to when you started managing the family's assets, at that time, that single stock represented about 60% of the family's wealth. A significant portion. So, our main task when we started was to add diversification, right?
Gus: Yeah. The challenging thing about that, even though, Colette's company had been bought and then bought again, so it wasn't the original entity. She still had this entrepreneur's dilemma, where she thought that it was undervalued, and then not to mention, that tax is implied when you sell something that has a near zero cost basis. It is from a tax perspective, punitive.
Erik: And I also remember us building that asset allocation worksheet kind of over and over and over again , and, looking at, holy smoly, if this thing goes up, fantastic. If this thing halves itself, we have a generational issue.
Gus: Yeah.
Erik: And so here we were, you know, it was, it, it is the legacy position of Colette, and her success sitting there and, and it had been a wonderful asset for decades. Yet, looking forward, maybe that wasn't going to continue to be the case. And so, after you got established, we came across the idea of exchange funds. And now, now not to be confused with exchange traded funds, which a lot of people are, but with exchange funds.
Jamie: Before they continue, let's define exchange funds. And to do that, I've asked Meghan Mahoney to join us. She's the head of Morgan Stanley's Concentrated Equity Specialist team.
Meghan: An exchange fund is for eligible investors, which means an individual whose total net worth is five million or more, and your primary residence doesn't count. And if you're an entity, that number's gonna jump to twenty-five million. So, exchange funds are private funds that provide a path towards immediate diversification. I think the best way I'd describe it is a party. It's a stock swap or exchange club where everyone brings their concentrated stock to the party. They're gonna put it in a basket, and after seven years, they leave with a diversified portfolio instead of the single position that they brought to the party. And so, investors have two choices. They can sell that position today and pay a tax bill, which, in most cases, is going to be significant. Or, they can leverage something like an exchange fund, which is designed for investors who want diversification, they want to dial back and right-size the risk that these positions represent in their portfolios, but they're not quite ready to write a check to the IRS today. And I think the important thing is to remember, with all of these strategies, while you might not be paying the tax bill today, you are kicking that tax bill into the future. So it's deferral, not elimination.
Jamie: Okay. Back to Gus and Erik.
Gus: You know, and the one thing people love to say "baskets", but I'll just share with you that sometimes when I think about the exchange fund, what I think of it as is a, uh, potluck. You know, you bring your macaroni and in exchange, you get to have a burger and maybe a little steak and some of that great potato salad.
Erik: And I think what the neat thing is, is when they're creating that basket, whoever is running the exchange fund, whichever investment company is running the exchange fund, they're trying to build a basket which is gonna help them mirror the performance of something, whether it be an index, whether it be another investment portfolio. And so, there is a lot of thought put into what shares, what companies are they allowing to come into this. And we were pretty lucky at the time that Colette's position was one of the positions they were looking for. Your family is very, very similar in a way to all of our successful clients that you have this incredible concentrated position. It's done super well for you. You want to try to diversify it, but diversifying everything all at one shot probably doesn't make a whole lot of sense. And so, we have done different vintages of exchange funds at different years, at different times, following different indices.
Gus: Yeah. One of the other advantages is the idea of diversification while deferring the tax bill, you know. And the tax bill is always going to come. But, you know, let's say for instance, we wanted just to take a small piece of this, take a million dollars and diversify it. Without the exchange fund, we sell it. Federal long-term gain, it's 20%. We pay $200,000 there. We have the NIIT surtax, that's 38,000. We have the state of Illinois, nearly 5%, that's another 50,000. So at the end, if we tried to sell the stock directly and redeploy it, we only have $712,000 approximately.
Erik: Totally.
Jamie: The NIIT surtax Gus mentioned is the net investment income tax. If you earn above certain income levels, you may pay an extra 3.8% tax on investment income like capital gains, dividends, and interest.
Gus: That's one of the, the really attractive things, again, returning to the basket or the potluck.
Erik: Totally.
Gus: You know, when you hear the quick pitch that you put your stock in and it gets, mixed in with others and you get this diversified basket back, I mean, it kinda sounds too good to be true. And then, you know, once you start to dig into it and you realize that the line that is not being crossed here is that you're not selling something in order to participate in this exchange fund. You're contributing to it. So there's no property transaction that's happened. And so, that's kind of the key point of how this thing works.
Erik: The other part that, a lot of people that we run into and talk to about exchange funds, they know about it, the seven-year rule, and believe you can't touch it for seven years. The seven-year rule doesn't actually exist like people think about it.
Jamie: So, how does the seven-year rule work? I've asked Meghan to explain it.
Meghan: This comes up all the time. And we actually often hear it described as a lockup. Remember, exchange funds typically offer daily liquidity, but there are some key considerations and important dates to keep in mind. First, if the client chooses to redeem inside the first three years, there will be an early redemption fee, otherwise known as a clawback, and that typically will be around one percent of the fund's net asset value. And if you choose to redeem inside seven years, you will get back your initial contributed stock, but it will be subject to the performance of the fund. And finally, after seven years, that's when the IRS considers you fully divorced from your initial contribution. What that means is you receive back a basket of securities that the portfolio manager is going to choose. It's at their discretion. The investor can select the size of that basket, meaning it could be a basket of one stock, three to five stocks, or even as many as 20 to 30.
Jamie: To hear my full conversation with Meghan about our whole range of concentrated stock strategies, check out our special episode in the feed now.
Erik: So Gus, it's important to remember that different funds have different structures, rules, and penalties. It can be quite complex, and you need to evaluate what's most suitable for your situation. And another thing that people often don't understand about exchange funds is about the cost basis. The cost basis is the original purchase price of an asset for tax purposes. And so, in your situation, the cost basis was when your grandmother acquired the shares. Now, when you contribute to an exchange fund, you bring it with you to the exchange fund basket.
Gus: Absolutely. In fact, that's a misconception that is often floated around these things is, is once you put the money in, if you wait the seven years, the key number, is that you get a diversified basket with an increased cost basis, and that is completely wrong.
Erik: And I think the other part that's really hard for people to grasp in going into an exchange fund because it might seem like I'm diversifying from this stock that's been really good for me, and I know I wanna diversify, and so I, I'm gonna do this, and it seems like a till death do we part kind of move, and that maybe we're in this basket forever and ever and ever. We're almost 20 years into this vintage, and things have changed.
Gus: Yeah. I mean, the finance industry is so interesting because things are evolving, changing. Some opportunities go away and, and new ones come up. And that's what's really interesting is there are new solutions that are available for people with this concentrated position or maybe better said, there are new solutions for people who have low cost basis issues.
Erik: That is true. And with our new solution, we're taking part of that diversified basket of stocks that the exchange fund gave us approximately twenty to thirty stocks. So less concentration with our low cost basis. And we're gonna be moving this into the Parametric long-short portfolio. And exchange funds continue to be extremely important to your family, but there is no single strategy, right, that's a silver bullet. And now, we get to pair our exchange fund portfolios with the Parametric long-short strategy. And so this creates an optimal tailored recipe for your family's unique circumstance. The long-short fund is really about more control. It allows for you to further customize based on your sector and value preferences. And it's gonna let us actively harvest the losses, something that we could not do in the exchange funds. So this is essentially helping us soften the tax bill as we continue to sell down the concentrated position. It's gonna be such a win-win for your family.
Gus: Yeah. The one thing that I really like about the Parametric long/short extension is that it, it's held in a separately managed account, so we have daily liquidity, which we didn't have with the exchange fund. We've gotten away from the 20% sleeve of real estate, which our family has enough of already from Colette's good work. And, yeah, it's able to use some tax strategies that the exchange funds can't do. I sort of think of it as organizational optimization. So, at the time we did this, exchange funds absolutely solved our problem, and now there's a little tweak we can make.
Erik: Yeah, it's very interesting how far we've come, right? Because when we first received the diversified basket of stocks at the end of the seven-year period, I remember were just happy to leave them be.
Gus: Yeah. I never really thought about using this option of taking things out, because the investments were doing what they were supposed to. They were diversifying us. They were performing fairly well. But you can see that, wait a sec, I have more control because the stocks are in my account. I have daily liquidity, and there's this new tax strategy that we can deploy because when we need to distribute funds to the family, we have to sell something which is going to have large gains embedded in it. This long/short extension is able to help mitigate some of the tax liability from the process of generating distribution funds. You know, it's sort of a stage thing. You do the exchange fund first. It, you know, works like we wanted it to, and now that we're able to take the basket out, it's another facet of that investment that's working for us.
Erik: Yeah, a hundred per cent. Again, this is one of the things I've always appreciated about our multi-decade relationship, is your curiosity and how we're able to continue to look at new strategies and see how does this new strategy work with what has worked to further create some optimized solutions for you and your family?
Gus: That's like so much of our relationship is that we try these things together. We, you know, argue about how they fit, how they don't fit, and then we watch the organizational optimization happen.
Erik: Yes, indeed. The organizational optimization. And I think this is probably a great place to sum up our experience together. We started this whole thing together with a large stock position, and that was brought into the exchange funds for diversification. And here we are, this many decades later. We're moving into the long-short strategy. It's a new strategy for us, but we're confident about it, and looking forward to how this is gonna help our organizational optimization, as you like to say, and kind of the interesting thing for you and I is, what do you think the needs of the family are gonna be over the next five to ten years?
Gus: Yeah. Well, I think the education never stops, you know? I mean, we talk about educating the younger kids, which is essential, but we're also educating the, you know, the older generation too. The grantors, as you might say. The other thing that, um, might not resonate with everybody out there, but, uh, the way we are formed in the family office is we have a general investment pool, and that doesn't really work perfectly when you have multi-generations and you have different risk profiles. And I could see in the future maybe what we have are different pools in which people transfer back and forth into depending on the risk appetite they have and the investment horizon. You know, having a 90-year-old with the same investment portfolio as a, uh, you know, 10-year-old, doesn't make a lot of sense, except for that's the only way it can work at the moment.
Erik: Yeah, and, and as you know, you and I have talked a lot about this issue because we have a pretty large group coming through in the next generation, and we've done a lot of wealth education with them. They are in a much better place, a much more sophisticated place than maybe other generations before them when looking at investments. So, it is gonna be interesting, and we do have options for them, to carve out and create and co-create investment pools for our later generations as they get older. I, I'm really looking forward to this. This is gonna be kind of an exciting time and, and something to look forward for both of us.
Gus: Yeah. Yeah.
Erik: I have certainly, as always, appreciated getting time to talk with you about your family and this multi-decade walk that we've done together through so many different investment cycles. And being able to be together and address the needs of the family with so many different options and being flexible, uh, this has been certainly one of the most fun things professionally I've ever done. So I, I thank you for your time and our friendship.
Gus: Yeah. Well, thank you. I, you know, I'm gonna be in Seattle next month, so maybe you and I can, uh, find a, a piano somewhere.
Jamie: If you'd like a deeper dive on exchange funds, long-short strategies, family wealth management, or if you wanna learn more about our toolkit to navigate your own concentration risk, check out morganstanley.com/mymoney. I'm Jamie Roô. Talk to you soon.
DISCLAIMER: This material has been prepared for general reference and educational purposes only. It does not provide individually tailored investment advice. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. Please see our show notes for a full disclaimer on the information provided.
