Section 4.1: Investment Companies

  • Definition and Purpose

    • The Investment Company Act of 1940 defines and regulates investment companies in the U.S.

    • The most common type is the mutual fund.

    • An investment company is a corporation or trust that pools investors’ money and invests it in securities on their behalf.

    • Each fund has a clearly defined investment objective, such as growth or income.

    • Pooling funds gives small investors the:

      • Purchasing power of large investors.

      • Diversification benefits.

  • Regulation

    • Investment companies raise capital by selling shares to the public.

    • They must meet registration and prospectus requirements under the Securities Act of 1933.

    • The Investment Company Act of 1940 regulates how shares are sold to the public and classifies investment companies into three main types:

πŸ”’ Types of Secured Bonds

1. Face-Amount Certificate (FAC) Companies

  • A contract between an investor and an issuer.

  • The issuer guarantees payment of a stated (face) amount at a future date.

  • The investor agrees to pay:

    • A lump sum (single payment), or

    • Periodic installments over time.

  • FACs are defined as investment companies under the 1940 Act.

  • Not managed β€” once established, the portfolio remains fixed.

  • Redeemable only through the issuer (not traded in the secondary market).

2. Unit Investment Trusts (UITs):

  • Organized under a trust, not a corporation.

  • Managed by trustees (no board of directors).

  • Create a fixed portfolio designed to meet the trust’s objectives.

  • Investors purchase redeemable units (shares) representing an undivided interest in the entire portfolio.

  • The portfolio is fixed β€” no active management and little or no portfolio turnover.

  • Have a fixed end date or maturity:

    • Debt-based UIT ends when the last bond matures.

    • Equity-based UIT ends when all securities are sold and funds distributed.

  • No management fees because the portfolio is not actively traded.

  • Redeemable only with the issuer at intervals stated in the prospectus.

  • Non-fixed UITs (contractual plans) exist but are less common.

  • Not traded in the secondary market.

3. Management Companies:

  • The most familiar type of investment company.

  • Actively managed to achieve a stated investment objective.

  • Two main types:

    • Closed-End Funds

    • Open-End Funds (Mutual Funds)

1940

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1940 〰️

Closed-End Management Companies:

  • Raise capital through an Initial Public Offering (IPO) of a fixed number of shares.

  • After the IPO, the fund is closed to new investors.

  • May issue common stock, preferred stock, or bonds.

  • Shares trade in the secondary market β€” like ordinary stocks.

  • Market price determined by supply and demand, not directly by NAV.

  • Shares may trade:

    • Above NAV (premium), or

    • Below NAV (discount).

  • Also called publicly traded funds.

  • The Net Asset Value (NAV) is the fund’s total asset value divided by the number of shares, but market price can differ.

Open-End Management Companies (Mutual Funds):

  • Continuously offer new shares to investors β€” no limit on the number of shares issued.

  • Only issue common stock (no preferred stock or bonds).

  • May borrow money to meet redemption requests or expenses.

  • Shares are redeemable directly from the fund at the current NAV.

  • No secondary market trading β€” all transactions are with the fund itself.

  • NAV is recalculated at least once per business day (end of trading day).

  • May issue fractional shares.

  • While mutual funds issue only common shares, their portfolios may include stocks, preferred shares, and bonds.

Classification of Investment Companies

Type / Structure / Managed? / Shares Redeemable? / Trades in Secondary Market? / Notes

  • Face-Amount Certificate (FAC) / Contract / ❌ No / βœ… Yes (with issuer) / ❌ No / Fixed return at maturity

  • Unit Investment Trust (UIT) / Trust / ❌ No / βœ… Yes (with issuer) / ❌ No / Fixed portfolio; no management fees

  • Closed-End Fund / Corporation / βœ… Yes / ❌ No / βœ… Yes / Trades at premium or discount to NAV

  • Open-End Fund (Mutual Fund) / Corporation / βœ… Yes / βœ… Yes (at NAV) / ❌ No / Continuous offering; priced daily

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✺ Review questions ✺

  • A. Securities Act of 1933
    B. Investment Advisers Act of 1940
    C. Investment Company Act of 1940
    D. Securities Exchange Act of 1934
    βœ… Answer: C

  • A. Closed-End Fund
    B. Open-End Fund
    C. Unit Investment Trust (UIT)
    D. Hedge Fund
    βœ… Answer: C

  • A. Open-End Fund
    B. Closed-End Fund
    C. UIT
    D. FAC
    βœ… Answer: B

  • A. Closed-End Fund
    B. UIT
    C. Open-End Fund (Mutual Fund)
    D. FAC
    βœ… Answer: C

  • A. Managed portfolios
    B. Trade on the secondary market
    C. Redeemable only with issuer
    D. Pay dividends
    βœ… Answer: C