Exchange Funds - Its doesnt...

In typical lovely CFAI style, we get two answers that say opposing things

2007 AM exam, question 2, Part A, if one selected exchange fund.

“a private exchange fund will retain soem exposure to upside price movements”

Part B, reasons to not select and Exchange fund:

If Candidate Chose “equity collar”, then one can eliminate Exchange Funds because

“This strategy would eliminate any significant upside potential assoicated with the position in Pitt”

So which is it? Do Exchange funds preserve upside or not? Why would they not, I mean the stock is in the exchange fund - once the exchange takes place, so why woudl they not be exposed to its movement, albeit in lower proportions?

they are talking of a private exchange fund - where a whole host of investors with similar concentrated stock positions are coming together to put their stocks together with a well placed investor who buys same security at market prices. This is an UNRELATED INVESTOR. This partnership hedges / borrows / reinvests and provides the original investors with the diversification they need. This softens the blow of sale of a low basis stock and allows the original investor to retain some potential upside movement.


Both answers are in CFAI speak saying the same thing…

you need to read carefully. They are NOT saying opposite things. That is the CFAI world.

CP, you are truly awesome. Im gonna hate it when you pass this year and I am stuck back here for trip number 3 down that road without your insight…

that aint a given …

I am able to dissect an answer after the fact - perfect hindsight bias.

but what I do on June 2nd is what will really matter :slight_smile:

I dont understand why exchange funds dont have upside potential…


  1. What does the unrelated investor do, exactly? Buy the stock and then the fund uses the money to purchase diversifying positions?

  2. What are the mechanics of this transaction (the formation of the private exchange fund)?

im reading in the text and the mechanics of the transaction aren’t really explained, its just "there is an unrelated investor and this allows one to acheive the diversification effects. It softens the psychological blow becaue the investor gets to retain soem of the upside potential.

the unrelated investor is buying the stock at current market prices. So he is buying it at say 100$.

the original investor had purchased it as a low basis stock (so say at 50$).

Combined together - the partnership has a bigger asset base - which can be used without triggering the constructive sale rule - the transactions (hedging/borrowing/reinvesting) that can be used to reduce the concentrated position. And this also softens the blow of selling - since the original investor can participate in some gains …

  1. So does it raise the basis by essentially averaging the unrelated investors pricing with the basis of the original investors’

  2. So they take the bigger asset base, borrow against it and either hedge or diversify by buying other positions in unrelated securities??

not sure about the real mechanics… but I do not think that is needed for the next 3 weeks.