Investment Companies Overview
Before diving into specific product types, you need to understand the legal framework that governs all investment companies.
The Investment Company Act of 1940
The Investment Company Act of 1940 (ICA) is the federal law that defines and regulates investment companies. Its core purpose is to protect investors who pool their money into professionally managed portfolios.
- Investment companies pool money from many investors to invest in a diversified portfolio of securities
- The ICA establishes registration requirements, disclosure obligations, and operational standards
- All investment companies must register with the Securities and Exchange Commission (SEC) under the ICA
Key ICA Sections
Three sections of the ICA define the classification system you need to know:
| ICA Section | What It Does |
|---|---|
| Section 3(a) | Defines what an investment company is |
| Section 4 | Classifies investment companies into three types |
| Section 5 | Sub-classifies management companies (open-end vs. closed-end; diversified vs. non-diversified) |
Exam Tip: Gotchas
- Section 4 classifies investment companies into types; Section 5 sub-classifies management companies. These are often confused on the exam.
Three Types of Investment Companies
Think of it this way: The ICA is like a building code for the investment world. Before a company can pool investors' money and manage it, the ICA tells them exactly what type of company they are, what rules they follow, and how they must be structured.
Section 4 of the ICA defines exactly three types:
| Type | Description | Prevalence |
|---|---|---|
| Face-amount certificate company | Issues certificates promising to pay a fixed sum at maturity in exchange for periodic payments | Extremely rare today |
| Unit investment trust (UIT) | Fixed portfolio of securities with no active management; issues redeemable units | Common for bond portfolios |
| Management company | Actively or passively managed portfolio with a board of directors and investment adviser | By far the most common |
Exam Tip: Gotchas
- The ICA defines exactly three types of investment companies; not two, not four. Face-amount certificate companies are rarely tested in detail, but you need to know they exist as one of the three types.
- UITs are NOT management companies; they have no investment adviser or board of directors.
Management Company Sub-Classifications
Section 5 further divides management companies along two dimensions:
By share structure:
| Type | Key Feature |
|---|---|
| Open-end (mutual fund) | Continuously issues and redeems shares at net asset value (NAV) |
| Closed-end | Issues a fixed number of shares via initial public offering (IPO); trades on an exchange |
By portfolio concentration:
| Type | Requirement |
|---|---|
| Diversified | At least 75% of assets: no more than 5% in any single issuer, no more than 10% of any issuer's voting securities |
| Non-diversified | Does not meet the diversified standard; can concentrate holdings |
Exam Tip: Gotchas
- Management companies are the only type further sub-classified (into open-end and closed-end).
- "Diversified" has a specific legal meaning under Section 5 - it is not just about holding many securities. It requires at least 75% of assets to meet the 5%/10% test.