351 exchanges are gaining momentum, and most firms are underestimating the risk

The industry is at an inflection point. 351 exchanges are moving from niche to mainstream rapidly. The question isn't whether these strategies have value; they demonstrably do, allowing investors to diversify highly concentrated stock positions without tax consequences.  The question is which advisors will develop the operational capability to deliver that value reliably.

We completed approximately $900 million in 351 conversions across two funds earlier this year, among the largest active mutual fund-to-ETF conversions of 2025. That experience revealed something the industry conversation is missing: execution complexity is being systematically underestimated. Not because the strategy is flawed, but because most firms lack the operational infrastructure these transactions demand.

Where theory meets operational reality

The IRS diversification test for Section 351 isn't a single calculation. It's a multi-dimensional analysis accounting for position sizing and concentration, limitations, and timing.

Here's what makes this treacherous: market movements between analysis and execution can invalidate initially clean testing. A 2% rally in a concentrated position can push you over diversification limits. If that happens after clients have committed but before execution of the conversion, you're either forcing contribution adjustments or aborting entirely. Neither outcome is acceptable.

The custodial wildcard

Here's an operational reality most advisors won't discover until execution: custodian competence with 351 exchanges varies dramatically. Some have processed these transactions successfully and established protocols. Others claim capability but have never executed one.

Before recommending a 351 exchange, verify your custodian has successfully completed these specific transactions, not that they "support" them in theory. Get references from advisors who have used that custodian for 351s. Confirm their systems handle basis reporting accurately. Ask about their turnaround times and what went wrong in their most challenging transaction. This operational due diligence is non-negotiable.

The coming wave and what it means

Based on our experience and industry trajectory, 351 exchanges will become table stakes for RIAs serving high-net-worth clients within 24 months. The drivers are clear: regulatory acceptance is solidifying as more conversions execute successfully.

ETF product innovation is expanding addressable opportunities, clients no longer need to choose between tax efficiency and active management. And advisor competitive pressure is intensifying. Once sophisticated RIAs in a market demonstrate 351 capability, it creates pressure on others to develop that capability or risk losing high-net-worth prospects.

But this coming wave creates risk. As 351 exchanges move mainstream, execution quality will likely deteriorate. Firms will rush to offer the service without building proper operational infrastructure. Fund sponsors will emerge without adequate track records. The gap between marketing promises and execution capability will widen.

The due diligence framework that matters

Advisors evaluating fund sponsors for 351 transactions should focus on execution, and ask questions that reveal readiness:

• Diversification testing: Walk me through your methodology. How do you handle market movement between testing and execution? What's your contingency protocol if a position moves outside limits after client commitment?
• Cost basis integrity: What happens when custodial records don't match client tax records? Show me your reconciliation process. How do you validate basis accuracy before reporting to investors?
• Execution timeline: What's the critical path? Where are your single points of failure? What delays have you encountered and how did you resolve them?
• Custodial coordination: Which custodians have you worked with successfully? Can you provide references? What custodian-related issues have you encountered?

Specific answers signal real experience. General assurances do not. If a sponsor can't answer these questions with specificity, they're not ready, regardless of their marketing materials.

Building capability responsibly

Section 351 exchanges represent another level in tax-efficient wealth management. The strategic value is clear. The addressable market is enormous. Advisors who develop genuine capability will capture meaningful market share.

But capability requires operational infrastructure. It means multi-month planning timelines with systematic verification at every step. Tax and legal specialists engaged from the beginning, not brought in to solve problems. Established relationships with operationally competent custodians. Parallel verification systems for basis tracking and diversification testing. Contingency protocols for common execution challenges. And honest assessment of whether your firm's infrastructure can support this complexity.

The winners in this evolving market will be advisors who respect execution complexity and invest in proper infrastructure now. The losers will be those who treat 351 exchanges as routine transactions they can execute casually.

The benefits are real. So are the risks. The difference lies in preparation, discipline, and understanding what this structure truly demands. Choose your partners carefully. Your clients' outcomes and your firm's reputation depend on it.

Jason Marcus is chief operating officer and chief compliance officer at Scharf Investments.