Investment Companies

The Investment Company Act of 1940

The Investment Company Act of 1940 is the primary federal law governing investment companies. It established the regulatory framework for how investment companies are organized, how they operate, and how they are sold to the public. This Act is administered by the Securities and Exchange Commission (SEC).

Under the Act, an investment company is defined as any company that is primarily engaged in the business of investing, reinvesting, or trading in securities. The Act classifies investment companies into three types:

1. Management companies: The most common type, further divided into open-end (mutual funds) and closed-end funds. These companies actively manage a portfolio of securities.
2. Unit Investment Trusts (UITs): Fixed portfolios of securities held in trust. They do not have a board of directors or investment adviser.
3. Face-amount certificate companies: Rarely issued today. These are debt instruments where the company promises to pay a stated (face) amount at a future date.

Key Provisions of the 1940 Act

• At least 40% of the board of directors must be non-interested (independent, outside) persons. For funds that use 12b-1 fees, a majority of the board must be independent.
• Investment companies must have a clearly stated investment objective that can only be changed by a majority vote of shareholders.
• Custody of fund assets must be maintained by a qualified custodian (typically a bank).
• Shares cannot be sold on margin and cannot be sold short.
• Fund shares cannot be purchased with borrowed money (except closed-end funds under certain conditions).
• The fund must distribute at least 90% of net investment income to shareholders to qualify as a regulated investment company (RIC) under Subchapter M of the Internal Revenue Code and avoid paying corporate taxes on distributed income.

Open-End Funds (Mutual Funds)

Open-end management companies, commonly known as mutual funds, are the most popular type of investment company. They are "open-end" because they continuously issue new shares and redeem existing shares directly with investors. There is no limit to the number of shares that can be issued.

Net Asset Value (NAV)

The Net Asset Value (NAV) is the per-share value of a mutual fund, calculated once per day after the market close (4:00 PM ET). The formula is:

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

Forward Pricing

Mutual fund shares are always bought and redeemed at the next calculated NAV. This is called forward pricing. If you place an order at 2:00 PM, you will receive the NAV calculated after the 4:00 PM market close. If you place an order after 4:00 PM, you receive the next business day's NAV. Investors do not know the exact price when they place their order.

Public Offering Price (POP)

For funds that charge a front-end sales charge (load), the Public Offering Price (POP) is higher than the NAV:

POP = NAV + Sales Charge

Or equivalently: POP = NAV / (1 - Sales Charge %)

For no-load funds, POP = NAV (no sales charge is added).

Share Classes: A, B, and C

Mutual funds typically offer multiple share classes, each with a different fee structure. The three most common are Class A, Class B, and Class C shares. Understanding the differences is critical for suitability recommendations on the Series 7.

Class A Shares

• Front-end sales charge (load): Charged at the time of purchase. Deducted from the initial investment. Typical charges range from 3% to 5.75%.
• Lower 12b-1 fees: Typically 0.25% or less annually.
• Breakpoint discounts: The sales charge percentage decreases as the dollar amount invested increases. This makes Class A shares most suitable for larger investors.
• Best for: Larger investments and long-term holding periods.

Class B Shares

• No front-end sales charge: The entire investment is put to work immediately.
• Back-end sales charge (CDSC): Contingent Deferred Sales Charge assessed when shares are redeemed. Typically starts at 5-6% and declines by 1% per year, eventually reaching 0% (usually after 6-8 years).
• Higher 12b-1 fees: Typically 0.75% to 1.00% annually while the CDSC is in effect.
• Conversion: After the CDSC period expires, Class B shares automatically convert to Class A shares (with lower 12b-1 fees).
• No breakpoints: B shares do not qualify for breakpoint discounts.
• Best for: Smaller investments held for long periods. Note: Many fund companies have discontinued Class B shares.

Class C Shares

• Level load: No or very small front-end charge (typically 0-1%). Small back-end charge (typically 1%) if redeemed within the first year.
• Higher ongoing 12b-1 fees: Typically 1.00% annually for the life of the investment.
• No conversion: C shares do not convert to A shares. The higher 12b-1 fee continues indefinitely.
• No breakpoints: C shares do not qualify for breakpoint discounts.
• Best for: Shorter holding periods (1-3 years) or smaller investments.

Breakpoints and Sales Charge Reductions

Breakpoints are volume discounts on the front-end sales charge for Class A mutual fund shares. As the dollar amount invested increases, the sales charge percentage decreases according to a schedule published in the fund's prospectus.

Typical Breakpoint Schedule

Letter of Intent (LOI)

A Letter of Intent (LOI) allows an investor to receive a reduced sales charge by committing to invest a specified dollar amount over a 13-month period. The investor receives the breakpoint discount immediately on all purchases. If the investor fails to meet the commitment, the fund will retroactively charge the higher sales load.

Key facts about LOIs:

• Valid for 13 months from the date of signing
• Can be backdated up to 90 days to include a recent purchase
• The fund holds a portion of shares in escrow as collateral until the LOI is fulfilled
• Not a binding contract; the investor is not obligated to invest the full amount
• If unfulfilled, the investor pays the difference in sales charges

Rights of Accumulation (ROA)

Rights of Accumulation (ROA) allow an investor to receive breakpoint discounts based on the current total value of all shares already owned in the same fund family, plus the new purchase amount. Unlike an LOI, which looks forward, ROA looks at the existing account value.

Breakpoint Sales Violations

Fees, Expenses, and Distributions

12b-1 Fees

12b-1 fees (named after SEC Rule 12b-1) are annual fees paid from fund assets to cover marketing, distribution, and sometimes shareholder servicing costs. These fees are included in the fund's expense ratio and reduce the fund's return.

• Maximum 12b-1 fee: 1.00% annually (0.75% for distribution + 0.25% for service fees)
• If a fund charges more than 0.25% in 12b-1 fees, it cannot call itself a "no-load" fund
• 12b-1 fees are deducted daily from fund assets, reducing NAV over time
• Must be approved by a majority of independent directors and by a majority of outstanding shares

Expense Ratio

The expense ratio represents the total annual operating expenses of a fund expressed as a percentage of average net assets. It includes management fees, 12b-1 fees, administrative costs, and other operating expenses. It does NOT include sales charges (loads), brokerage commissions on portfolio trades, or interest expenses.

Redemption Fees

Some funds charge a redemption fee (typically 1-2%) on shares redeemed within a short period (e.g., 30-90 days) to discourage short-term trading and market timing. Unlike a CDSC, the redemption fee goes back into the fund (benefiting remaining shareholders) rather than to the distributor.

Exchanges (Conversions)

Most fund families allow shareholders to exchange shares from one fund to another within the same family, often at NAV (no additional sales charge). However, an exchange is a taxable event: the redemption of the original fund triggers a capital gain or loss.

Distributions

Mutual funds make two types of distributions to shareholders:

• Income distributions: Dividends and interest earned by the fund's portfolio, minus fund expenses. Taxable as ordinary income to the shareholder (even if reinvested).
• Capital gains distributions: Net gains realized when the fund sells securities from its portfolio at a profit. Taxable as capital gains to the shareholder (long-term rates if the fund held the securities for more than one year).

Shareholders may choose to receive distributions in cash or reinvest them in additional fund shares. Reinvested distributions are still taxable in the year received.

Closed-End Funds

Closed-end funds (also called closed-end management companies) issue a fixed number of shares through an initial public offering (IPO) and then trade on stock exchanges like regular stocks. Unlike mutual funds, closed-end funds do not continuously issue or redeem shares.

Key Characteristics

• Fixed number of shares: After the IPO, no new shares are issued (except through secondary offerings)
• Exchange-traded: Shares trade on stock exchanges (NYSE, Nasdaq) throughout the day at market-determined prices
• Price vs. NAV: Shares can trade at a premium (above NAV) or discount (below NAV) to their net asset value, depending on supply and demand
• Can use leverage: Closed-end funds can issue preferred stock or borrow money (use debt leverage) to amplify returns. This increases both potential gains and potential losses.
• No redemption at NAV: Investors sell shares on the exchange at the market price, not to the fund at NAV

Exchange-Traded Funds (ETFs)

Exchange-Traded Funds (ETFs) are investment funds that trade on stock exchanges throughout the day, similar to stocks. Most ETFs are passively managed and track an index (e.g., S&P 500, Nasdaq-100), although actively managed ETFs have become increasingly common.

Creation and Redemption Process

ETFs have a unique creation/redemption mechanism that helps keep their market price close to NAV:

• Authorized Participants (APs): Large institutional investors or market makers who have agreements with the ETF sponsor to create or redeem ETF shares
• Creation: An AP delivers a "basket" of the underlying securities (matching the fund's portfolio) to the ETF sponsor and receives a large block of ETF shares called a "creation unit" (typically 25,000-50,000 shares)
• Redemption: An AP delivers creation units back to the ETF sponsor and receives the basket of underlying securities in return
• Arbitrage mechanism: If the ETF trades at a premium to NAV, APs create new shares (buy underlying securities, exchange for ETF shares, sell on market), pushing the price back toward NAV. If it trades at a discount, APs redeem shares (buy ETF shares, exchange for underlying securities, sell them), pushing the price back up.

Tax Efficiency

ETFs are generally more tax-efficient than mutual funds because of the in-kind creation/redemption process. When mutual fund investors redeem shares, the fund may need to sell securities to raise cash, triggering capital gains for all remaining shareholders. ETFs avoid this because redemptions are done in-kind (securities exchanged for securities), not through market sales.

Other ETF Characteristics

• Can be bought and sold throughout the trading day at market prices
• Can be purchased on margin and sold short (unlike mutual funds)
• Typically have lower expense ratios than mutual funds (especially index ETFs)
• No minimum investment beyond the price of one share
• Standard brokerage commissions apply (many brokers now offer commission-free ETF trading)
• Investors pay the bid-ask spread when trading

Unit Investment Trusts (UITs)

A Unit Investment Trust (UIT) is a type of investment company that holds a fixed portfolio of securities assembled by a sponsor at the time the trust is created. The portfolio is not actively managed; securities are generally held until maturity (for bond UITs) or for a specified period (for equity UITs).

• No board of directors or investment adviser: Unlike management companies, UITs have a trustee but no management team making ongoing investment decisions
• Trust units (not shares): Investors purchase units that represent an undivided interest in the trust's portfolio
• Fixed portfolio: Securities in the portfolio do not change (except for rare circumstances like defaults or mergers)
• Self-liquidating: UITs have a stated termination date. Bond UITs terminate when the bonds mature. Equity UITs have a set dissolution date.
• Redeemable: UIT units can be redeemed with the trustee at NAV at any time
• Sales charge: UITs typically charge a small sales charge (1-4%)

Investment Company Comparison