Two clients can each say "I own a fund" and mean opposite things. One can redeem today and be paid within a week. The other may wait ten years for her money. The vehicle's structure decides which.
A pool that mainly invests in securities and sells interests to investors is an investment company. The Investment Company Act of 1940 governs it. Section 4 sorts investment company types into three classes:
- Face-amount certificate companies: Investors pay installments and receive a stated face amount at maturity. These are rare.
- Unit investment trusts (UITs): These are trusts with no board of directors that issue only redeemable units.
- Management companies: This class covers every other investment company.
Section 5(a) divides management companies into open-end and closed-end. An open-end company issues redeemable shares. Holders can return those shares to the fund for their proportionate share of net assets. Any other management company is closed-end.
Investors read "diversified" as a sign that no single issuer can sink the fund, so the Act sets a numeric test before a fund may use the label.
Common mistakes
- Saying closed-end funds never issue shares. They can run rights or follow-on offerings. What they never do is sell continuously or redeem on demand.
- Equating accredited with qualified purchaser. $1,000,000 of net worth makes a client accredited. A qualified purchaser needs $5,000,000 in investments.
- Using the old $10 million ceiling. The 250-owner allowance now stops at $12,000,000 of contributions and uncalled commitments.
Bottom line
- Investment Company Act Section 4 sorts investment companies into face-amount certificate companies, UITs and management companies.
- Section 5 splits management companies into open-end (redeemable shares) and closed-end (every other management company).
- A diversified fund keeps 75% of assets in qualifying holdings, each capped at 5% of fund assets and 10% of an issuer's voting shares.
- Open-end funds trade only with the fund at the next computed NAV (Rule 22c-1) and must pay redemptions within seven days (Section 22(e)).
Exam shortcut
Sort each stem by its exit: "Redeems with the fund" points to an open-end fund or UIT. "Sells on an exchange" points to a closed-end fund, an ETF or a listed REIT. "Lockup," "gate" or "capital call" points to a private fund. Then match the clock. Fund redemptions get seven days, exchange trades settle T+1, and buyout and venture money is tied up for about ten years.
The full lesson (about 3,610 words, 24 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- B12
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