Investment Company Structure

With the tax framework in place, you can now see the three vehicles Subchapter M applies to: open-end funds, closed-end funds, and Unit Investment Trusts (UITs). Exchange-Traded Funds (ETFs) are a hybrid that blends open-end or UIT structure with secondary-market trading.

How does the Investment Company Act classify a fund?

The Investment Company Act (ICA) of 1940 classifies in two steps, and the exam tests the difference between the statutory taxonomy and the practical one.

Step 1: the three statutory classes. Every investment company is a face-amount certificate company, a unit investment trust, or a management company.

Step 2: subclassify the management companies. A management company is either open-end or closed-end, and separately either diversified or non-diversified. A diversified company meets the 75/5/10 test: at least 75% of total assets in cash, government securities, other investment companies, and other securities, with no more than 5% of total assets in any one issuer and no more than 10% of any one issuer's voting securities.

Exam Tip: Gotchas

• Open-end and closed-end are not top-level statutory classes. They are subclassifications of management companies. A question asking for the statutory classification that offers "open-end, closed-end, UIT" is offering the practical taxonomy, not the statutory one.

The practical distinction below is how shares are issued and priced.

Exam Tip: Gotchas

• Only mutual funds issue shares that are redeemable directly with the issuer. Closed-end funds and ETFs are traded in the secondary market: the investor sells to another investor at market price, not back to the fund at NAV.
• "Redeemable" is the legal distinguisher under the Investment Company Act. Open-end funds and UITs issue redeemable securities; closed-end funds do not.

What are the characteristics of an open-end mutual fund?

Open-end funds are the flagship Series 6 product. The rep sells the fund, the customer sends money, the fund issues new shares, and the customer can redeem those shares back to the fund whenever they want.

• Net Asset Value (NAV): total assets minus total liabilities, divided by shares outstanding
• Forward pricing: purchase and redemption orders execute at the next-computed NAV after order receipt
  • Orders received before the fund's daily pricing time (typically 4:00 p.m. Eastern Time (ET) when U.S. markets close) receive that day's NAV
  • Orders received after 4:00 p.m. ET receive the next day's NAV
• Public Offering Price (POP) for a load fund: NAV + sales charge
• Exchange privileges within fund families: investors can swap between funds in the same family, typically without a new sales charge; each exchange is still a taxable event

Think of it this way: Forward pricing is like ordering at a restaurant with no prices on the menu. You place the order; you do not know the price until after the kitchen closes and the chef totals the day's receipts. This prevents someone who already knows today's price from "late trading" at a stale, known NAV.

Exam Tip: Gotchas

• Forward pricing is a one-way street. An order submitted at 3:58 p.m. ET gets today's 4 p.m. NAV; an order at 4:02 p.m. ET gets tomorrow's NAV. This is the rule that prevents late trading, covered later in this unit.
• Exchanges within a fund family are still taxable events even though no sales charge applies. The old fund is sold (gain or loss recognized) and the new fund is purchased.

Try it: Compute POP from NAV and sales load (or back-solve NAV from POP) with the NAV / POP / Sales Charge Calculator.

How does a closed-end fund differ from a mutual fund?

Closed-end funds raise money once, through an IPO, then let the shares trade on an exchange like any stock. The fund does not issue new shares on demand and does not redeem shares at NAV.

• Distributed in the primary market at the IPO price. A closed-end fund is not strictly limited to that one offering: later common-share sales are permitted in defined cases, such as a rights offering to existing holders
• Trade in the secondary market on an exchange; price driven by supply and demand
• Can trade at a discount or premium to NAV: closed-end shares do not have the NAV pricing constraint mutual funds do
• May issue senior securities (preferred stock and debt) subject to the senior-securities limitation:
  • Debt: 300% asset coverage required
  • Preferred stock: 200% asset coverage required

Think of it this way: A closed-end fund is like a closed cookie jar. Once the cookies (shares) are in the jar, no more get added and none come out directly. If you want cookies, you trade with someone else who already has some, and the price of those cookies on the open market can drift above or below the jar's official value.

Exam Tip: Gotchas

• Closed-end fund discounts are normal and common. A fund may trade 10-20% below NAV based on supply and demand alone. This is a feature of the closed-end structure, not a sign of distress.
• Open-end funds may only borrow from a bank, with 300% asset coverage. Closed-end funds have more leverage flexibility (debt + preferred) under the senior-securities limitation.

What is a Unit Investment Trust (UIT)?

A UIT is the simplest investment company: buy a basket of securities at inception, hold them unchanged, and terminate on a stated date.

• Fixed (unmanaged) portfolio assembled at inception and held to the termination date
• No board of directors, no investment adviser: the sponsor creates the trust, a trustee holds the assets, and the portfolio is static
• Redeemable units: investors can redeem with the sponsor at NAV; some UITs have a secondary market
• Terminate on a specified date; successive "series" are typically offered as prior series mature

Exam Tip: Gotchas

• UITs have no investment adviser and no portfolio manager. A UIT question asking "who manages the portfolio?" is a trick: the answer is "no one actively manages it; the portfolio is fixed."
• UIT units are redeemable at NAV even though the portfolio is fixed. The sponsor stands ready to redeem.

How are Exchange-Traded Funds (ETFs) structured?

ETFs combine the open-end or UIT structure with the secondary-market trading of closed-end funds. Most modern ETFs are structured as open-end management companies.

• Structure: open-end investment company (or UIT) registered under the ICA
• Trading: shares trade on an exchange like a closed-end fund
• Creation/redemption by authorized participants in large block units (typically 50,000 shares, called creation units) keeps market price close to NAV
  • ETFs typically trade within about 1% of NAV
• Intraday trading, margin eligibility, short-sale eligibility, and often lower expense ratios than traditional mutual funds
• Tax efficiency: in-kind creation and redemption minimizes taxable capital gains distributions at the fund level

Think of it this way: ETFs are a hybrid. To retail investors, they look and trade like stocks (buy through a broker, intraday, at market prices). Behind the scenes, authorized participants arbitrage any mispricing by creating or redeeming 50,000-share blocks at NAV, which is why ETF prices stay close to NAV even though they trade like closed-end funds.

Exam Tip: Gotchas

• ETF creation and redemption happen in kind at the authorized-participant level, not at the retail level. Retail customers buy and sell ETF shares on the exchange; they cannot redeem with the fund directly.
• ETFs trade like closed-end funds but stay close to NAV because of arbitrage by authorized participants. A closed-end fund has no authorized-participant mechanism, which is why closed-end discounts can persist.

What Should You Check on Exam Day?

• Do you know the ICA's three statutory classes are face-amount certificate companies, unit investment trusts, and management companies, with open-end and closed-end as subclasses?
• Can you state the 75/5/10 diversification test: 75% in cash, government securities, and other issuers, no more than 5% in one issuer and 10% of its voting securities?
• Do you know closed-end fund shares trade on an exchange and can trade at a discount or premium to NAV, unlike open-end shares priced at forward NAV?
• Can you explain why a UIT has no board and no investment adviser, since its portfolio is fixed at inception and held unchanged?
• Do you know authorized participants create and redeem ETF shares in large blocks at NAV, which keeps the market price close to NAV?