Exchange fund

An exchange fund or swap fund is a mechanism specific to the U.S., first introduced as early as 1954 with the passage of 26 U.S. Code § 721, that allows holders of a large amount of a single stock to diversify into a basket of other stocks without directly selling their stock.

The purpose of this arrangement is to diversify their holdings without triggering a "taxable event".  Note that the tax is not avoided, just deferred. When the diversified holdings are eventually sold, tax will be due on the difference between the sales price and the original cost basis of the contributed stock. Deferring taxes avoids tax drag, as the money lost to taxes remains invested in the market, which can lead to improved returns over time.

Detailed structure and eligibility
 Exchange fund participants are typically qualified purchasers with at least $5 million in investible assets. Investment minimums run from $500,000 to $1 million at firms like Eaton Vance and Goldman Sachs. 
 Fund holding requirements: A fund needs to have at least 20% of its assets in "non-publicly traded" securities or real-estate
 Liquidity: An investor must remain in the fund for at least seven years to receive a tax deferral. Redemptions before seven years can only be met with stocks contributed by the investor, and might be subject to penalties. Exchange funds are for investors with a long-term outlook.

Benefits and drawbacks
 Exchange funds diversify an investor's concentrated position, reducing concentration risk.
 Exchange funds reduce potential tax drag by allowing an investment's principal to grow while deferring capital gains taxes.
 Exchange funds help investors overcome several biases that can discourage them from diversifying a concentrated position (such as the anchoring bias that occurs when a stock loses value).
 Exchange require a long-term investment (of at least seven years). 
 Risks associated with exchange funds include liquidity risks, investment risks, tax law risks, leverage risks, and others.

Providers
Currently, exchange funds are primarily offered by two large investment firms. Eaton Vance (which was acquired by Morgan Stanley) is the largest of the public stock exchange fund providers and Goldman Sachs offers exchange funds as well.

Regulatory and Policy Questions
Exchange funds became popular after Eaton Vance obtained a private ruling from the IRS in 1975 allowing their use.  The U.S. Securities and Exchange Commission  has investigated the use of these arrangements with reference to the potential for market abuse by directors not disclosing their effective divestment in stocks for which they are privy to sensitive market information.

In addition, there is general public policy disagreement whether tax revenue that is generated from exchange funds and other like-kind exchanges should be deferred or avoided.  Many holders of appreciated positions may elect to hold the concentrated position and borrow against it rather than sell and pay the associated capital gains tax, which results in deadweight loss to the economy. Proponents argue that exchange funds help with this significant deadweight loss as holders of appreciated stock can diversify and liquidate their positions, reinjecting this capital into the economy. Opponents argue that exchange funds serve just a narrow slice of the population.  For example, politician Mitt Romney and businessman Eli Broad have been identified as using exchange funds to reduce their tax obligations.

Public vs. private equity exchange funds
Private equity exchange funds (those comprising stock in non-public companies) differ from public exchange funds in a few regards:
 A main objective of private equity exchange funds is providing participants with downside risk protection, in case their own stock becomes worthless before they achieve a liquidity event (an IPO or acquisition.)  The need for diversification can be higher than it is with public stock which may be sold at any time, if the holder wishes to bear the tax consequences.
 When liquidity events occur within a private equity fund, proceeds are immediately distributed to limited partners, rather than being held or reinvested. The objective of these funds is liquidity as well as diversification.
 Public funds are generally not marginable. Private funds may increase a participant's odds of liquidity.
 Fund management fees are assessed on the basis of an expense budget, rather than a percent of the value, since valuation of the private equity holdings is uncertain.
 Liquidity: For public exchange funds, at least seven years must elapse between when an investor deposits their stock and when the basket of stocks is available for them to sell without realizing a step up in basis (paying taxes). However, this is not an issue with private stock exchange funds as the point is diversification, not tax deferral.

References

Investment