Investment Company Classification Under the Investment Company Act of 1940
The Investment Company Act of 1940 provides the regulatory framework for all pooled investment vehicles. Before diving into specific products, you need to understand the three legal classifications and the diversification test that governs how funds describe themselves.
Three Types of Investment Companies
The 1940 Act defines exactly three types of investment companies:
| Type | Description | Key Feature |
|---|---|---|
| Face-amount certificate company | Issues debt certificates at a discount that pay a fixed amount at maturity | Rarely tested; virtually nonexistent today |
| Unit investment trust (UIT) | Issues redeemable units in a fixed portfolio; no board of directors or investment adviser | Fixed portfolio, no active management, set termination date |
| Management company | Actively managed portfolio overseen by a board of directors and investment adviser | Divided into open-end and closed-end funds |
- Face-amount certificate companies are essentially historical relics; know the name, but don't expect deep questions
- UITs and management companies are where the exam focuses its attention
- Every mutual fund, closed-end fund, and exchange-traded fund (ETF) falls under one of these three categories
Management Companies: Open-End vs. Closed-End
Management companies are further divided into two categories, and the differences are heavily tested:
| Feature | Open-End Fund (Mutual Fund) | Closed-End Fund |
|---|---|---|
| Share issuance | Continuously issues and redeems shares | Fixed number of shares issued at initial public offering (IPO) |
| Pricing | Forward-priced at net asset value (NAV) per Securities and Exchange Commission (SEC) Rule 22c-1 | Trades on exchanges at market price |
| Trading | Bought/redeemed through the fund | Bought/sold on secondary market |
| Premium/discount | Always transacts at NAV (plus any sales charge) | Frequently trades at a premium or discount to NAV |
| Leverage | Generally prohibited from issuing senior securities (Section 18) | May use leverage (issue preferred stock or debt with asset coverage requirements) |
Key distinction: Open-end funds create and destroy shares with every purchase and redemption. Closed-end funds issue a fixed number of shares once, then those shares trade like stocks.
Exam Tip: Gotchas
A closed-end fund issues shares at IPO and then trades on exchanges at market price, which can differ from NAV. An open-end fund continuously issues and redeems shares at NAV. The exam often presents scenarios where you must identify which fund type can trade at a premium or discount.
The 75-5-10 Diversification Test
A fund may call itself diversified only if it meets the 75-5-10 test:
- At least 75% of total assets must be invested in securities of other issuers, government securities, cash, or cash equivalents
- No more than 5% of total assets may be invested in the securities of any single issuer (applies to the 75% portion only)
- The fund may not own more than 10% of the outstanding voting securities of any single issuer (applies to the 75% portion only)
The remaining 25% of assets may be invested without these restrictions; the fund could put the entire 25% into a single issuer if it chose to.
A fund that does not meet this test must describe itself as non-diversified.
Exam Tip: Gotchas
The 75-5-10 test only applies to the 75% portion of the portfolio. The other 25% can be concentrated in any way the fund chooses. Exam questions may test whether the 5% and 10% limits apply to total assets or just the diversified portion; the answer is the 75% portion only.