Investment Company Basics

The three classifications

The 1940 Act divides investment companies into three types.

Face-amount certificate companies issue debt certificates promising a fixed sum at a fixed future date, paid for either in instalments or in a lump sum. They barely exist any more and appear on the exam only in the classification question.

Unit investment trusts hold a fixed, unmanaged portfolio. There is no board of directors and no investment adviser, because there is nothing to decide after the portfolio is assembled. Units are redeemable, the trust has a stated termination date, and the sponsor typically maintains a secondary market. UITs are the structure behind many defined-portfolio bond trusts and, historically, behind some exchange-traded products.

Management companies hold an actively or passively managed portfolio under an investment adviser, and they are what people mean by 'a fund.' They subdivide two ways.

By capitalization: open-end or closed-end. An open-end company — a mutual fund — continuously offers new shares and redeems them on demand, so the share count changes daily. A closed-end company issues a fixed number of shares in a one-time public offering and does not redeem them; investors who want out sell to other investors in the secondary market.

By diversification: diversified or non-diversified.

That produces the exam's central contrast. An open-end fund's shares are always priced from net asset value and are redeemed by the fund. A closed-end fund's shares trade on an exchange at whatever price supply and demand produce, which is frequently at a discount to net asset value and sometimes at a premium. A closed-end fund trading at a discount to NAV is a normal condition, not a mispricing to be reported.

One more structural difference: an open-end fund may issue only one class of voting stock, full-paid and non-assessable, and may not issue senior securities other than a bank borrowing subject to a 300 percent asset coverage requirement. A closed-end fund may issue debt and preferred stock. This is why leveraged municipal closed-end funds exist and leveraged open-end funds of the same design do not.

Diversification and the 75-5-10 test

Section 5(b)(1) of the Act defines a diversified management company by a test the industry calls 75-5-10.

With respect to 75 percent of its total assets, the fund may not hold more than 5 percent of its assets in the securities of any one issuer, and may not hold more than 10 percent of the outstanding voting securities of any one issuer.

The remaining 25 percent is unconstrained by the test. So a diversified fund may take a large position in one issuer, provided the rest of the portfolio satisfies the test — a nuance that catches candidates who read the rule as applying to the whole portfolio.

US government securities, cash and cash items, and securities of other investment companies are excluded from the calculation.

A non-diversified fund simply does not make that representation. Sector funds and concentrated funds are often non-diversified, and the classification is a disclosure matter rather than a prohibition. The suitability consequence is real: a non-diversified fund carries more issuer-specific risk, which is what the exam wants said when comparing two funds with similar objectives.

Governance and the rules on conduct

The Act imposes a governance structure and a set of prohibitions, several of which appear on the outline by section number.

Section 10 limits the affiliations of directors, requiring a minimum proportion of the board to be persons who are not interested persons of the fund — independent directors, in ordinary language. They exist to represent shareholders against the adviser, whose interests differ.

Section 15(a) requires the investment advisory contract to be in writing, to describe the compensation, and to be approved initially and then renewed annually by the board or by shareholders. An adviser cannot simply keep the mandate.

Section 13(a) requires a shareholder vote before the fund changes its stated investment policy, its classification from diversified to non-diversified, or its sub-classification. A growth fund cannot quietly become a high-yield bond fund.

Section 12(a) prohibits an open-end fund from purchasing securities on margin, from selling short, and from participating in joint trading accounts. These are the risk-taking behaviours the Act took off the table for a retail vehicle.

Section 17(a) prohibits transactions between the fund and its affiliates — an adviser cannot sell its own inventory into the fund it manages.

Section 19 requires that any distribution be accompanied by a written notice disclosing what portion comes from net investment income, from capital gains and from return of capital. A customer receiving a distribution funded partly out of capital deserves to know it.

Sections 35, 36 and 37 deal with misleading names and representations, breach of fiduciary duty, and larceny and embezzlement.

Alongside the fund sit its service providers: the investment adviser managing the portfolio, the custodian holding the assets, the transfer agent maintaining shareholder records and processing purchases and redemptions, and the underwriter or distributor selling the shares. The exam asks which one performs which function, and the answers are exactly as their names suggest.

Registration, disclosure and pricing

A fund registers twice: as a security under the Securities Act of 1933 and as an investment company under the 1940 Act. That is why a mutual fund is always sold with a prospectus — it is a continuous primary offering, every purchase is a purchase of newly issued shares, and Section 5 of the 1933 Act applies to every one of them.

The prospectus states the objective, the strategy, the risks, the fees in a standardized fee table and the performance history. The statement of additional information — the SAI — contains the fuller detail and must be provided free on request. Funds may deliver a summary prospectus under Rule 498 provided the full documents are available.

Pricing is governed by Rule 22c-1, the forward pricing rule. An order to buy or redeem is executed at the next computed net asset value, not the last one. Funds compute NAV at least once daily, typically at 4pm Eastern. The practical consequence is that a customer placing an order at 2pm does not know the price they will get, and a representative who quotes this morning's NAV as the price is wrong.

Net asset value per share is total assets minus total liabilities, divided by shares outstanding.

Conduit taxation

Left alone, a fund would create double taxation: the fund pays tax on its income, and the shareholder pays again on the distribution. Subchapter M of the Internal Revenue Code solves this by treating a qualifying fund as a conduit or pipeline.

A regulated investment company that distributes at least 90 percent of its net investment income to shareholders is taxed only on what it retains. The distributed income is taxed once, in the shareholder's hands. Qualification also requires meeting income-source and asset-diversification tests under IRC section 851.

The consequences for the customer are worth stating plainly, because they surprise people. Dividend and interest income distributed by the fund is taxable to the shareholder in the year distributed, whether taken in cash or reinvested. Capital gains distributed by the fund are taxed as long-term capital gains to the shareholder regardless of how long the shareholder has held the fund — the holding period that matters is the fund's, not yours. And a customer who buys a fund shortly before a large capital gain distribution receives income that is immediately taxable and is offset by an equal fall in the fund's NAV — buying a dividend, and a genuine reason to check a fund's distribution schedule before a large year-end purchase.

Reinvested distributions increase the shareholder's cost basis, which prevents them being taxed a second time on sale. Customers who forget this over ten years of reinvestment routinely overpay tax, and the representative is well placed to prevent it.