By Lewis Braham
Direct indexing with private accounts has become an increasingly popular alternative to mutual funds and exchange traded funds for tax-sensitive investors seeking to harvest every possible tax loss in their portfolios.
But what happens when a successful investor's account appreciates to the point where it runs out of individual stock losses to write off? The older the account is, the more likely it is that every stock in it may have a taxable gain. For this reason, a growing number of financial advisors are moving their clients in the opposite direction -- away from private accounts and toward ETFs.
351 exchanges. These tax maneuvers are known as 351 conversions after Internal Revenue Code Section 351. The strategy allows advisors to transfer clients' appreciated stock portfolios, which have unrealized capital gains, to a newly formed ETF. The ETF can then unload those appreciated stocks to ETF financial intermediaries known as authorized participants without the client paying capital-gains taxes. Such conversions involve advisors pooling client assets from individual separate accounts into a single ETF.
According to a 2026 white paper co-authored by Brent Sullivan, editor of the Tax Alpha Insider newsletter, some 39 ETFs launched between 2021 and 2025 via such 351 conversions. Those had about $8.7 billion of private account seed assets. The growth rate has accelerated recently with the advent of prepackaged turnkey conversion solutions, called syndicated 351 exchanges, from ETF sponsors like Alpha Architect and Cambria Investment Management.
"It's a favorable exchange for the clients, and it's a win-win for everybody except for the IRS," Sullivan told Barron's Advisor. "It's deferred taxation, so maybe [the IRS will be] taking a look at that."
Deferred taxation. The fact that the taxes are deferred rather than avoided is an essential point. When private accounts convert to an ETF, the financial custodian must maintain the account holders' tax cost basis for their private account portfolios in the conversion. That means that instead of having a portfolio of appreciated individual stocks, the clients now have appreciated ETF shares that are taxable when sold.
"A lot of people are talking about this as a tax dodge," says Daniel Sotiroff, an ETF analyst at Morningstar. "It's not really a tax dodge. It's just deferring the eventual capital gains. If you want to get your money out, you're still going to have to sell the ETF shares."
So what's the advantage of doing the conversion beyond tax deferral? For an actively managed private account run by the advisor, it allows the manager to shift the portfolio to new stocks and to diversify the portfolio to more stocks so it doesn't become concentrated in just a handful of companies.
This is the part historically tax regulators don't like, though. The IRS has "diversification tests," Sotiroff says. "So if you had a big position in, say, Tesla or Meta or Nvidia, or something that's been up huge, and it was a stand-alone position, and you wanted to convert just that position into an ETF, you couldn't do that."
IRS test. Regulators have what is called the "25/50 diversification test." No more than 25% of any client's portfolio converting to an ETF can be in one stock and the top five holdings can't be more than 50% of the portfolio. Any converted account that violates this test could cause the IRS to disallow the entire ETF conversion and subject clients to taxation of their accounts.
That said, outside of those parameters there is currently a lot of room to change up clients' portfolios. A fairly concentrated private account of 20 highly-appreciated tech stocks with each stock being 5% of the portfolio is legally already diversified even if the account subsequently converts into an ETF that owns hundreds of stocks in different sectors.
Sullivan believes the IRS and Congress might ultimately see such dramatic conversions as violating the spirit if not the letter of the law. "The IRS has not filled some of those gaps [in the law]," he says. "For decades now, there have been opportunities for folks who are really creative and leaning into the gray spaces to be able to achieve tax-free diversification. So what the Treasury [or IRS] could do is close those gaps. It should."
Meanwhile, advisors see an opportunity. Jason Marcus, the COO and chief compliance officer of Scharf Investments, did a combined 351 conversion of Scharf's mutual funds and clients' private accounts into two ETFs -- Scharf ETF (KAT) and Scharf Global Opportunity ETF (GKAT) -- last August.
"It's a very complicated and intricate process," Marcus says. "But we're very happy with the way things went. Obviously, it's not for everybody."
Between the two ETFs, the total pooled assets of client accounts after the conversion were approximately $900 million, he adds. "Clients can still see benefits with smaller asset sizes, but this isn't a cheap venture, so you need to have, I would say, in excess of probably $30 million for [the conversion] to basically pay for itself." The ultimate expense ratio for the client after conversion should decline above that threshold asset size.
Clearly, some advisors think 351 conversions are worth the effort. "I have many calls, like one a week, with other advisors that are interested in exploring this," Marcus says. "It's just there are a lot of moving pieces. It was probably the most intricate and complicated transaction of my entire 25-year career in this industry."
This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.
(END) Dow Jones Newswires
March 23, 2026 14:29 ET (18:29 GMT)
Copyright (c) 2026 Dow Jones & Company, Inc.
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