We are always looking for ways to improve the performance of our clients’ portfolios by providing high-quality investments while keeping fees low. All mutual funds and exchange-traded funds charge an expense ratio, which is the cost of operating the fund and includes the manager’s fee, as well as various other operating costs. These expenses are not the same as loads, so even a no-load fund has an expense ratio. While loads (sales commissions) are additional charges, expense ratios are internal costs that reduce the fund’s total return. We purchase no-load funds for our clients and endeavor to use funds with expense ratios that are low relative to peers. Still, within the universe of no-load funds there are various share classes, each of which charge a different expense ratio. While an individual might be able to purchase a no-load fund directly from the fund family, the expense ratio for the available share class will be higher than for an institutional share class of the same fund. The latter is reserved for larger investors (or institutions with many clients) and generally has a large minimum investment requirement. In exchange for the higher minimum, the fund charges a lower expense ratio.
Many times, we can access institutional share classes with lower expense ratios that are unavailable to individual investors. When we identify such an opportunity, we may participate in a tax-free mutual fund share class exchange on our clients’ behalf, essentially exchanging the existing shares for ones in the lower-fee share class. Since this is not considered a sell of one share class and a purchase of the other, no gains or losses are recognized and it is not a taxable event. Though there is usually a nominal transaction fee charged by the custodian for the swap, the savings on the lower internal mutual fund expenses outweigh this charge when the position size is sufficiently large and there is not expected to be much trading in the position.
Sometimes the custodian will issue a trade confirmation on the swap, which makes it look like we sold one share class and bought the other. Though that is technically true, it is essentially a non-taxable swap into a different share class of the same mutual fund, albeit one with a lower expense ratio. If you ever have a question regarding a mutual fund share class exchange or more generally a trade made in your portfolio, please don’t hesitate to reach out to your financial advisor.