Investment Companies

Overview of Investment Companies

Investment companies are the cornerstone of the Series 6 exam. These are entities that pool money from many investors and invest that capital in a diversified portfolio of securities. The Investment Company Act of 1940 is the primary federal law governing investment companies, and it defines three main types: face-amount certificate companies, unit investment trusts (UITs), and management companies. For the Series 6 exam, the majority of your focus will be on management companies, specifically open-end investment companies, commonly known as mutual funds.

The concept behind investment companies is straightforward: individual investors may lack the capital, expertise, or time to build a well-diversified portfolio on their own. By pooling money together, investment companies provide professional management, diversification, and economies of scale that would be difficult for individual investors to achieve independently.

The Investment Company Act of 1940

The Investment Company Act of 1940 is the foundational legislation that regulates the organization and activities of investment companies. Key provisions include requirements for registration with the SEC, restrictions on transactions between the fund and its affiliates, governance requirements (including independent board members), and restrictions on capital structure. Any company that issues securities and is primarily engaged in investing, reinvesting, or trading in securities must register under this act.

The act requires that at least 40% of the board of directors of an investment company be independent (not affiliated with the fund's investment adviser). In practice, most fund boards now have a majority of independent directors, which helps ensure that the interests of shareholders are protected.

Investment Company: An entity that pools capital from multiple investors and invests in a portfolio of securities. Governed by the Investment Company Act of 1940, investment companies must register with the SEC and adhere to strict governance, disclosure, and operational requirements.

Three Types of Investment Companies

The 1940 Act classifies investment companies into three categories:

Face-Amount Certificate Companies: These are the rarest type. They issue certificates that promise to pay investors a fixed sum (the face amount) at a specified future date. Investors pay either a lump sum or periodic installments. These are rarely issued today and are not a major focus of the Series 6 exam, but you should know they exist as one of the three types defined by the Act.
Unit Investment Trusts (UITs): A UIT is a registered investment company that purchases a fixed portfolio of securities and holds them until a predetermined termination date. UITs do not have a board of directors or an investment adviser that actively manages the portfolio. Once the trust is established, the portfolio is generally not changed. UITs issue redeemable units (not shares) to investors. The fixed nature of the portfolio means UITs are considered passively managed.
Management Companies: These are the most common type. Management companies employ an investment adviser who actively (or passively, in the case of index funds) manages a portfolio of securities. Management companies are further divided into two subtypes: open-end companies (mutual funds) and closed-end companies.

Open-End vs. Closed-End Funds

The distinction between open-end and closed-end management companies is one of the most heavily tested concepts on the Series 6 exam. Understanding how each type issues and redeems shares, how pricing works, and the structural differences is essential.

Open-End Funds (Mutual Funds)

An open-end investment company, commonly called a mutual fund, continuously issues new shares to investors and redeems (buys back) shares from investors who wish to sell. There is no limit to the number of shares that can be outstanding. When you buy shares of a mutual fund, the fund creates new shares for you. When you sell (redeem) shares, the fund cancels those shares and pays you the current net asset value (NAV).

Key characteristics of open-end funds include:

Continuous offering: Shares are always available for purchase directly from the fund or through authorized dealers.
Redeemable: Shareholders have the right to redeem their shares at NAV (plus or minus any applicable charges) at any time. The fund must redeem shares within seven calendar days of receiving a proper redemption request.
Forward pricing: Shares are bought and sold at the next calculated NAV, not at intraday market prices. NAV is typically calculated once per day after market close (4:00 PM ET).
No secondary market trading: Mutual fund shares do not trade on exchanges. All transactions occur directly with the fund company.
Professional management: The fund employs an investment adviser that makes buy and sell decisions for the portfolio.

Closed-End Funds

A closed-end investment company conducts an initial public offering (IPO) to raise capital, issues a fixed number of shares, and then those shares trade on an exchange (like the NYSE or Nasdaq) in the secondary market. Unlike mutual funds, closed-end funds do not continuously issue or redeem shares. If an investor wants to sell shares, they must sell them to another investor on the exchange, just like selling a stock.

Key characteristics of closed-end funds include:

Fixed capitalization: A set number of shares is issued at the IPO, and no new shares are created when investors buy.
Exchange-traded: Shares trade throughout the day on stock exchanges at market prices that may differ from NAV.
Premium or discount: Because shares trade on an exchange based on supply and demand, closed-end fund shares may trade at a premium (above NAV) or a discount (below NAV).
No redemption: The fund does not buy back shares from investors. Liquidity comes from the secondary market.

Feature	Open-End (Mutual Fund)	Closed-End Fund
Share Issuance	Continuous; unlimited shares	Fixed at IPO
How Shares Are Bought	Directly from fund company	On an exchange from other investors
Redemption	Fund must redeem at NAV within 7 days	No redemption; sell on exchange
Pricing	Forward pricing at NAV	Market price (may differ from NAV)
Trading	End of day only	Intraday on exchanges
Leverage Allowed	Generally no	Yes; may issue debt or preferred stock

The Series 6 exam focuses primarily on open-end funds (mutual funds). Remember that the Series 6 license permits the sale of mutual funds, variable annuities, and variable life insurance, but NOT closed-end funds on the secondary market (that requires a Series 7). Know the distinctions between open-end and closed-end, but expect most questions to be about mutual fund mechanics.

Net Asset Value (NAV)

The Net Asset Value (NAV) is the per-share value of a mutual fund and is the most important pricing concept for the Series 6 exam. NAV represents what each share of the fund is worth based on the market value of the fund's underlying portfolio, minus any liabilities.

NAV Calculation

The formula for NAV is straightforward:

NAV = (Total Assets - Total Liabilities) / Number of Shares Outstanding

Total Assets include the current market value of all securities in the portfolio, plus cash, plus any accrued income. Total Liabilities include any debts or expenses owed by the fund. The result is divided by the total number of shares currently outstanding.

For example, suppose a mutual fund holds securities with a total market value of $500 million, has $2 million in cash, and owes $2 million in liabilities. If the fund has 50 million shares outstanding, the NAV would be:

NAV = ($500M + $2M - $2M) / 50M = $500M / 50M = $10.00 per share

Mutual funds are required to calculate their NAV at least once per business day, typically at the close of trading on the NYSE (4:00 PM Eastern Time). The NAV reflects the closing prices of all securities in the fund's portfolio.

Forward Pricing

Forward pricing is a fundamental rule for mutual fund transactions. It means that all purchases and redemptions of mutual fund shares are executed at the next calculated NAV after the order is received. If you place an order to buy mutual fund shares at 2:00 PM, you will receive shares at the NAV calculated at 4:00 PM that day. If you place an order at 5:00 PM (after the market closes), you will receive the next business day's NAV.

This rule is established under SEC Rule 22c-1 and is designed to ensure that all investors are treated fairly. Unlike stocks, which fluctuate in price throughout the day, mutual fund shares are always transacted at the next calculated NAV. There is no intraday trading of mutual fund shares.

Public Offering Price (POP)

While investors redeem shares at NAV, the price they pay to purchase shares may include a sales charge (also called a sales load). The price investors pay is called the Public Offering Price (POP):

POP = NAV + Sales Charge

For no-load funds (funds without a front-end sales charge), the POP equals the NAV. For load funds, the sales charge is added to the NAV. The maximum sales charge allowed under FINRA rules is 8.5% of the POP, though most funds charge considerably less.

To calculate the sales charge percentage:

Sales Charge % = (POP - NAV) / POP x 100

Note that the sales charge percentage is always calculated as a percentage of the POP (not the NAV). This is an important distinction that appears frequently on the exam.

A mutual fund has a NAV of $20.00 and a POP of $21.25. What is the sales charge percentage?

Sales Charge % = ($21.25 - $20.00) / $21.25 = $1.25 / $21.25 = 5.88%

The investor pays $1.25 per share as a sales charge, which represents 5.88% of the POP.

Diversified vs. Non-Diversified Funds

The Investment Company Act of 1940 establishes specific criteria that distinguish diversified and non-diversified management companies. This classification affects how concentrated a fund's portfolio can be and has direct implications for risk.

Diversified Fund Requirements

Under the 1940 Act, a diversified management company must meet the "75-5-10" test with respect to at least 75% of its total assets:

75%: At least 75% of the fund's total assets must be invested in securities of other issuers (not the fund's own securities or government securities).
5%: Of this 75%, no more than 5% of the fund's total assets can be invested in the securities of any single issuer.
10%: The fund cannot own more than 10% of the outstanding voting securities of any single issuer.

The remaining 25% of the fund's assets are not subject to these restrictions. This means a diversified fund could theoretically invest up to 25% of its assets in a single company, though this would be unusual in practice.

The 75-5-10 rule applies to only 75% of the fund's total assets, not 100%. Many exam questions try to trick you by suggesting that the 5% and 10% limits apply to the entire portfolio. They do not. The other 25% is unrestricted.

Non-Diversified Funds

A non-diversified fund is any management company that does not meet the 75-5-10 test. Non-diversified funds have greater flexibility to concentrate their holdings in fewer issuers or sectors. While this can lead to higher returns if the concentrated positions perform well, it also means significantly higher risk. Sector funds (funds that invest exclusively in one industry, such as technology or healthcare) are often non-diversified.

If a fund classifies itself as diversified, it must receive shareholder approval to change to non-diversified status. This protects investors who chose the fund based on its diversified classification.

Deep Dive Subchapter M and Tax Treatment of Investment Companies

Investment companies that qualify as "regulated investment companies" (RICs) under Subchapter M of the Internal Revenue Code receive favorable tax treatment. To qualify, a fund must distribute at least 90% of its net investment income to shareholders and meet certain diversification and income source requirements. The key benefit is that the fund avoids double taxation: the fund itself is not taxed on the income and gains it distributes to shareholders. Instead, shareholders pay taxes on the distributions they receive.

If a fund fails to meet Subchapter M requirements, it would be taxed as a regular corporation, and distributions to shareholders would also be taxed, resulting in double taxation. This is why virtually all mutual funds comply with Subchapter M requirements.

The income source requirement states that at least 90% of the fund's gross income must come from dividends, interest, and gains from the sale of securities. The diversification requirement under Subchapter M (which is separate from the 1940 Act diversification rules) requires that at the end of each fiscal quarter, at least 50% of the fund's assets must consist of cash, U.S. government securities, and securities of other RICs, with no single issuer representing more than 5% of total assets. Additionally, no more than 25% of the fund's assets can be invested in any one issuer.

Share Classes

One of the most important and frequently tested topics on the Series 6 exam is the different share classes available for mutual funds. Share classes represent different ways that investors pay for the costs of owning a mutual fund, particularly the sales charges and ongoing distribution fees. The most common share classes are Class A, Class B, and Class C shares.

Class A Shares

Class A shares charge a front-end sales load, which means the sales charge is deducted from the investor's initial purchase amount. For example, if an investor puts $10,000 into a Class A share fund with a 5% front-end load, $500 goes to the sales charge and $9,500 is actually invested in the fund.

Key features of Class A shares:

Front-end load: Paid at the time of purchase, reducing the amount invested.
Lower 12b-1 fees: Class A shares typically have lower annual distribution fees (12b-1 fees), often around 0.25%, compared to Class B or C shares.
Breakpoint discounts: Investors who purchase larger amounts receive reduced sales charges at specified breakpoint levels.
Best for long-term, larger investments: Because of the lower ongoing expenses and breakpoint availability, Class A shares often have the lowest total cost for investors making larger investments and holding for the long term.

Class B Shares

Class B shares charge a back-end sales load, also known as a Contingent Deferred Sales Charge (CDSC). No sales charge is deducted at the time of purchase, so the full investment amount goes to work immediately. However, if the investor redeems shares within a specified period (typically 6-8 years), a declining sales charge is assessed on the amount redeemed.

Key features of Class B shares:

Back-end load (CDSC): Charged upon redemption, typically declining over time (e.g., 5% in year 1, 4% in year 2, down to 0% after year 6-8).
Higher 12b-1 fees: Typically 0.75% to 1.00% annually, which increases the fund's expense ratio.
Automatic conversion: Class B shares typically convert to Class A shares after the CDSC schedule expires (usually 6-8 years), reducing ongoing expenses.
No breakpoints: Breakpoint discounts are not available for Class B shares.
FINRA restrictions: FINRA has limited the sale of Class B shares in recent years, and many fund families have discontinued them.

Class C Shares

Class C shares are sometimes called "level-load" shares because they charge a relatively constant annual fee rather than a large upfront or back-end charge. They typically have a small CDSC (often 1%) that applies only if shares are redeemed within the first year.

Key features of Class C shares:

Level load: Small or no front-end load, with a small CDSC (usually 1% if redeemed within 1 year).
Higher 12b-1 fees: Similar to Class B at 0.75% to 1.00%, but these fees continue indefinitely because Class C shares do not convert to Class A.
No conversion: Unlike Class B, Class C shares do not convert to Class A, so the higher ongoing expenses persist.
No breakpoints: Breakpoint discounts are not available.
Best for shorter holding periods: Investors who plan to hold for 1-3 years may find Class C shares advantageous because they avoid a large front-end load.

Feature	Class A	Class B	Class C
Sales Charge Timing	Front-end (at purchase)	Back-end (at redemption)	Level (ongoing)
12b-1 Fees	Low (~0.25%)	High (~0.75-1.00%)	High (~0.75-1.00%)
Breakpoints	Yes	No	No
Conversion	N/A	Converts to A after CDSC period	No conversion
Best For	Large, long-term investments	Smaller investments held long-term	Short to mid-term holding periods

On the Series 6 exam, you may be asked which share class is most suitable for a customer based on their investment amount and time horizon. Remember: Class A is generally best for large investments held long-term (due to breakpoints and lower ongoing costs). Class C is typically best for shorter-term investors. Class B shares are rarely recommended today. Selling Class B shares when Class A breakpoints would result in lower costs is a suitability violation known as a "breakpoint sale."

12b-1 Fees

Named after SEC Rule 12b-1, these are annual fees that mutual funds charge to cover distribution and marketing costs. They are deducted from fund assets, which reduces the NAV and, consequently, investor returns. FINRA limits 12b-1 fees to a maximum of 0.75% for distribution fees plus an additional 0.25% for service fees, for a total maximum of 1.00%. A fund that charges more than 0.25% in 12b-1 fees cannot call itself a "no-load" fund.

Expense Ratio

The expense ratio represents the total annual cost of owning a mutual fund, expressed as a percentage of the fund's average net assets. It includes the management fee (paid to the investment adviser), 12b-1 fees, administrative costs, and other operating expenses. The expense ratio does NOT include sales loads or brokerage commissions on portfolio trades. Investors should compare expense ratios across similar funds because even small differences can significantly impact long-term returns.

Other Investment Company Structures

Exchange-Traded Funds (ETFs)

While ETFs are technically registered as open-end funds or UITs, they have unique characteristics that differentiate them from traditional mutual funds. ETFs trade on exchanges throughout the day like stocks, offer intraday pricing, and typically have lower expense ratios than actively managed mutual funds. Most ETFs track an index (passive management). While Series 6 representatives primarily sell mutual funds, understanding ETFs is important for recommending suitable investments.

Money Market Funds

Money market funds are a special type of open-end mutual fund that invests in short-term, high-quality debt instruments such as Treasury bills, commercial paper, and certificates of deposit. They aim to maintain a stable NAV of $1.00 per share (though this is not guaranteed). Money market funds provide liquidity and safety of principal but typically offer lower returns than other types of mutual funds. They are subject to SEC Rule 2a-7, which imposes strict requirements on portfolio quality, maturity, and diversification.

Money market funds are NOT the same as bank money market accounts. Money market funds are securities products that are NOT insured by the FDIC. Bank money market accounts are deposit products that ARE insured by the FDIC up to $250,000. This distinction is frequently tested on the Series 6 exam.

Fund of Funds

A fund of funds is a mutual fund that invests in other mutual funds rather than directly in stocks or bonds. Target-date retirement funds are a common example: they hold a mix of stock and bond funds, gradually shifting to a more conservative allocation as the target retirement date approaches. Fund of funds provide automatic diversification and asset allocation, but investors should be aware that they may involve multiple layers of fees.