Exchange funds are drying up

Exchange funds are the passenger pigeons of mutual funds.

Like this now-extinct pigeon, whose numbers dwindled to a point where it could no longer be saved, exchange fund shareholders are falling off by attrition.

''The number of shares, as well as the assets, steadily decreases year by year,'' observes Laurie Corbett of Eaton & Howard, Vance Sanders Inc., one of the few brokerage houses still managing this type of fund.

''We still reinvest dividends four times a year, but there's not much new income in that,'' she adds.

Exchange funds were banned in a 1967 IRS ruling, because they were such obvious tax dodges. Squeezing through a loophole in the code, brokerage houses had found they could start an exchange fund if they made it a limited partnership in either California or Nebraska. Then the Tax Reform Act of 1976 tightened the code, preventing formation of the funds altogether.

Even before the funds became illegal, an investor had to be on his toes to buy into them. Only on a designated ''exchange day'' could he acquire shares. The next day the fund was closed.

Exchange funds appealed to the investor who had seen his stock appreciate greatly in value, but didn't want to pay capital gains taxes. For example, if you purchased 100 shares of Control Data Corporation stock at $12 a share in late 1966, you would have seen the price soar to $80 a share a year later. If you sold the stock, you would have had to pay taxes on $6,800.

If you had bought into an exchange fund, however, you would have traded in your Control Data stock for shares of the exchange fund. The fund would value your shares at that day's market value, and it would give you a corresponding number of exchange-fund shares.

For tax purposes, however, your stock would be valued at cost - that is, at $ 12 a share - the disappearing-capital-gains trick. When the fund manager decided to sell some shares of the fund, the fund would pay capital gains taxes and charge the investors. In essence, all investors pooled their unrealized capital gains and paid an average tax on those gains.

In this way you defered paying large capital gains taxes until you redeemed your shares of the exchange fund, presumably, when you were in a lower tax bracket.

Exchange funds still exist because they have been well managed. Eaton & Howard's seven funds have performed, on average, 1.8 percent better than the Standard & Poor 500 index over the different lives of the funds.

But exchange-fund assets are dwindling. When Eaton & Howard, Vance Sanders Inc. opened its Diversification Fund in 1961, its assets exceeded $91 million. Now, at $46.6 million in assets, the fund has shriveled by half. And when you factor in inflation, the decrease is 86 percent, or 8 percent a year.

No one can buy new shares, except by reinvesting dividends, and shareholders eventually redeem or transfer their shares. In 1961, the Diversification Fund claimed 1,171 shareholders. Only 571 remain.

While the drop in assets doesn't affect a shareholder's individual equity, it does imply that at some point there won't be enough assets to warrant managing the fund. It would be hard to say just what that point is.

Meanwhile, exchange funds will continue on their quiet flight, hopefully gliding above the S&P - and federal capital gains taxes, of course.

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