An exchange privilege is the right of a mutual fund shareholder to move money from one fund to another fund in the same fund family, usually at net asset value (NAV) and without paying a new sales charge. The investor sells shares in one fund and uses the proceeds to buy shares in another, in a single instruction, often by phone or online. The terms, including any limits on how often it can be used, are set out in the fund's prospectus.
The privilege is mainly valuable for funds sold with loads: an investor who has already paid a front-end load can change funds without paying it again. In the United States, exchange offers between funds of the same investment company group are governed by SEC Rule 11a-3 under the Investment Company Act of 1940. In the UK and Europe the same feature is usually called a switch.
The exchange privilege in plain terms
An exchange privilege is like a rail pass that lets you change trains within one company's network without buying a new ticket. You paid once to get on, and you can switch lines as your plans change. Leave the network, and you are buying a fresh ticket elsewhere.
With funds, the "network" is the fund family. If your goals change, say from growth to income as retirement approaches, you can move from a stock fund to a bond fund at the same company without paying the entry fee a second time. The move still counts as selling one fund and buying another, which matters for tax.
How exchanges work
An exchange is processed as a redemption from one fund and a purchase of another on the same day, both at the NAVs calculated after the order is received. Typical terms include:
- Same family, often same class. Exchanges are usually allowed only into the same share class of another fund in the family, for example Class A to Class A.
- Minimums. The exchange must meet the minimum initial or additional investment of the fund being bought.
- Money market parking. Many families let investors move into an affiliated money market fund and back again without losing credit for loads already paid.
- Frequency limits. Funds commonly cap the number of round trips a year or reject exchanges that look like short-term trading.
Rule 11a-3 and sales charges
SEC Rule 11a-3 sets out what a fund group may charge on an exchange. It may charge a uniform administrative fee that covers processing costs or is nominal; a redemption fee no larger than it would charge on an ordinary sale; and a front-end load only for the difference, if any, between the load on the new fund and the loads already paid. If the original shares carry a contingent deferred sales charge (CDSC), it cannot be collected at the time of the exchange. Instead, any CDSC on a later sale is calculated as if the investor had held the new shares since buying the original ones. The rule also requires at least 60 days' notice to shareholders before an exchange offer is ended or materially changed, except where a fee is simply reduced or removed.
For example, an investor who paid a 2.25% load on a bond fund and exchanges into an equity fund with a 5.75% load may be charged up to the 3.50% difference, depending on the fund's terms. An investor moving in the other direction pays no new load.
Market timing and limits
Free and fast exchanges made funds attractive to market timing traders, who moved large sums in and out to profit from stale prices, especially in international funds whose holdings had stopped trading hours before the fund's NAV was struck. These trades raised costs and diluted returns for long-term shareholders. The 2003 mutual fund trading scandal, in which several fund companies were found to have let favoured clients time their funds, led the Securities and Exchange Commission (SEC) to adopt Rule 22c-2 in 2005. It requires fund boards to consider a redemption fee of up to 2% on shares sold soon after purchase and to have agreements that give funds access to trading data from intermediaries. Many funds now restrict exchanges within 30 to 90 days of a purchase.
Tax treatment
An exchange avoids a new sales charge, but it does not avoid tax. In the US, the Internal Revenue Service treats an exchange of shares in one fund for shares in another as a sale followed by a purchase, so the investor realises a capital gain or capital loss on the shares given up. Whether the gain is a short-term capital gain or a long-term capital gain depends on how long those shares were held. Exchanges inside a tax-advantaged account such as an individual retirement account (IRA) or a 401(k) plan do not create a taxable event. In the UK, a switch between different funds held outside an ISA or pension is likewise a disposal for capital gains tax.
Used sensibly, the privilege supports asset allocation changes and rebalancing within one fund family. Its value has declined as investors use fund platforms and exchange-traded funds (ETFs), where switching between providers carries no load in the first place.