Quick Answer
The Investment Company Act of 1940 defines three types of investment companies: face-amount certificate companies, unit investment trusts (UITs), and management companies. Management companies split into open-end and closed-end funds. A fund may call itself "diversified" only if it passes the 75-5-10 test.
The Investment Company Act of 1940 provides the regulatory framework for registered investment companies, the pooled vehicles offered to the public (private funds such as hedge funds are excluded and are not registered investment companies). Before diving into specific products, you need to understand the three legal classifications and the diversification test that governs how funds describe themselves.
What Are the Three Types of Investment Companies?
The 1940 Act defines exactly three types of investment companies: face-amount certificate companies, unit investment trusts (UITs), and management 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
Open-End vs. Closed-End: What's the Difference?
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 the SEC's forward-pricing requirement | 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 (Investment Company Act senior-securities limitation) | 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.
When Can a Fund Call Itself "Diversified"?
A fund may call itself diversified only if it meets the 75-5-10 test:
- At least 75% of total assets must qualify: cash and cash items, government securities, securities of other investment companies, or other securities meeting the issuer limits
- For those other securities in the qualifying portion, the single-issuer asset limit is 5% of total fund assets, not 5% of the 75% portion
- Those other securities must also meet the limit of 10% of any issuer's outstanding voting securities. Cash, government securities, and securities of other investment companies are not subject to these issuer limits
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.
For example, a $300 million fund has a $15 million single-issuer asset cap within the qualifying portion. An $18 million position is 6% of total assets, but does not by itself prove that the fund fails.
If other holdings worth at least $225 million meet the test, the $18 million position can fit in the unrestricted portion. Classification depends on the qualifying assets across the portfolio, not a permanent label attached to each holding.
A fund that does not meet this test must describe itself as non-diversified.
Exam Tip: Gotchas
Separate where the limit applies from how it is calculated. The issuer limits apply to the qualifying 75% portion, while the 5% asset cap is calculated using total fund assets. A single position above 5% does not automatically defeat diversified status because the other 25% is outside these issuer limits.
What Should You Check on Exam Day?
- Can you name all three investment-company types under the 1940 Act, and identify which two the exam actually tests (UITs and management companies)?
- Do you know that management companies split into open-end (mutual fund) and closed-end funds, and can you name the pricing and leverage differences between them?
- Can you distinguish the qualifying 75% portion from the unrestricted 25%, and calculate the 5% issuer cap using total fund assets?