Overview
Investment companies pool money from multiple investors to purchase securities, providing diversification and professional management. Governed primarily by the Investment Company Act of 1940, they come in several distinct forms, each with unique structures, pricing mechanisms, and regulatory requirements. Mastery of these distinctions is critical for the SIE Exam.
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1. Types of Investment Companies
Overview of the Three Main Types
Under the Investment Company Act of 1940, all investment companies fall into one of three categories:
| Type | Key Feature |
|------|------------|
| Management Companies | Actively or passively managed portfolios (open-end or closed-end) |
| Unit Investment Trusts (UITs) | Fixed, unmanaged portfolio; no board of directors |
| Face-Amount Certificate Companies | Issue contracts promising a fixed future payout |
Management Companies: Open-End vs. Closed-End
• Open-End (Mutual Fund)
- Continuously issues and redeems shares
- Shares priced at NAV (not on an exchange)
- No fixed number of shares outstanding
- Transactions occur directly with the fund
• Closed-End Fund
- Issues a fixed number of shares through an IPO
- Shares trade on a secondary market (stock exchange)
- Price determined by supply and demand — can trade at a premium or discount to NAV
- No ongoing redemption directly with the fund
Unit Investment Trusts (UITs)
• Holds a fixed, unmanaged portfolio of securities
• Issues redeemable units to investors
• No board of directors or active investment adviser
• Terminates at a set date when portfolio matures or is liquidated
Exchange-Traded Funds (ETFs)
• Trade on a stock exchange throughout the day at market prices
• Combine features of mutual funds and closed-end funds
• Priced continuously (not just once per day)
• Mutual funds are purchased/redeemed at NAV once per day
Face-Amount Certificate Companies
• Issue contracts to investors who make periodic installment payments
• Company obligated to pay a fixed (face) amount at a future date
• Rarely seen in modern markets but still tested on the SIE
Key Terms
• Open-end fund – Mutual fund that continuously issues/redeems shares at NAV
• Closed-end fund – Fixed shares trading on a secondary market
• UIT – Fixed, unmanaged portfolio with redeemable units
• ETF – Exchange-traded fund priced throughout the day
• Face-amount certificate – Contract for a fixed future payment in exchange for installments
⚠️ Watch Out For
• ETFs look like open-end funds but trade like stocks — don't confuse their pricing mechanism
• UITs are not actively managed — no board of directors, no investment adviser
• Closed-end funds can trade at a discount or premium to NAV; mutual funds always transact at exact NAV
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2. Mutual Fund Structure & Pricing
Net Asset Value (NAV)
$$\text{NAV per share} = \frac{\text{Total Assets} - \text{Total Liabilities}}{\text{Total Shares Outstanding}}$$
• Calculated at the close of each business day (4:00 PM ET)
• Represents the per-share value of the fund's underlying portfolio
Public Offering Price (POP)
$$\text{POP} = \frac{\text{NAV}}{1 - \text{Sales Charge \%}}$$
• POP = NAV + any applicable front-end sales charge (load)
• A no-load fund: POP = NAV (no sales charge added)
Example:
> NAV = $9.50, Sales Charge = 5%
> POP = $9.50 ÷ (1 – 0.05) = $9.50 ÷ 0.95 = $10.00
Forward Pricing Rule
• All mutual fund orders (purchases and redemptions) execute at the next NAV calculated after the order is received
• Prevents market timing abuses
• Regardless of when during the day an order is placed, it prices at the next close
No-Load Funds
• No front-end or back-end sales commission
• Shares bought and redeemed at NAV
• May still charge management fees and 12b-1 fees (up to 0.25% to qualify as "no-load")
Key Terms
• NAV – Net asset value per share; calculated daily at market close
• POP – Public offering price; NAV plus applicable sales charge
• Forward pricing – Orders executed at next calculated NAV
• No-load fund – Fund with no front-end or back-end sales charge
⚠️ Watch Out For
• NAV and POP are not the same unless the fund is no-load
• The sales charge percentage is calculated on the POP, not the NAV
• Even no-load funds can charge operating expenses — "no-load" only means no sales commission
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3. Sales Charges & Share Classes
Mutual Fund Share Classes Comparison
| Feature | Class A | Class B | Class C |
|---------|---------|---------|---------|
| Front-End Load | Yes (reduced at breakpoints) | No | No |
| Back-End Load (CDSC) | No (usually) | Yes (decreases over time) | Small or none |
| 12b-1 Fee | Low | Higher | Higher |
| Conversion | N/A | Converts to Class A after holding period | Does not convert |
Front-End Load (Class A)
• Sales charge deducted from the initial purchase
• Reduces the amount actually invested
• Subject to breakpoint discounts
• Maximum allowed: 8.5% of POP
Contingent Deferred Sales Charge (CDSC) – Class B
• Back-end charge imposed when shares are redeemed
• Decreases over time (e.g., 5% in year 1, 4% in year 2… 0% after year 6)
• Class B shares often convert to Class A after the CDSC period expires
12b-1 Fees
• Annual fee charged to cover distribution and marketing expenses
• FINRA Maximum: 1.00% of average net assets per year
- 0.75% distribution fee
- 0.25% service fee
• Funds charging more than 0.25% in 12b-1 fees cannot call themselves no-load
Breakpoints
• Dollar thresholds at which investors qualify for reduced front-end sales charges
• Broker-dealers are required to inform investors of available breakpoints
• Can be reached through:
- Single lump-sum purchase
- Letter of Intent (LOI)
- Rights of Accumulation
Letter of Intent (LOI)
• Non-binding agreement to invest a specified amount within 13 months
• Allows investor to receive breakpoint discount immediately
• If investor does not meet the stated amount, additional charges may apply
• Can be backdated up to 90 days
Rights of Accumulation
• Allows investor to combine current holdings + new purchases to qualify for a breakpoint
• Based on the current value of existing fund holdings (not original cost)
• Does not require a new commitment; works automatically
Key Terms
• Front-end load – Sales charge at time of purchase (Class A)
• CDSC – Back-end charge upon redemption that decreases over time (Class B)
• 12b-1 fee – Annual distribution/marketing fee; max 1% per year
• Breakpoint – Investment threshold for reduced sales charges
• LOI – Letter of intent; 13-month commitment for breakpoint pricing
• Rights of accumulation – Combining existing and new investments for breakpoints
⚠️ Watch Out For
• Breakpoint selling is a violation — intentionally splitting purchases to avoid breakpoints is prohibited
• LOIs are non-binding but not without consequence — shortfalls result in back charges
• The 8.5% maximum load applies only if the fund offers rights of accumulation, LOI, and reinvestment of dividends at NAV; otherwise, the maximum may be lower
• 12b-1 fees come out of fund assets — they reduce NAV over time
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4. Regulatory Framework
Investment Company Act of 1940
• Primary federal law governing investment companies
• Regulates structure, operations, and disclosure requirements
• Registration required when a fund has 100 or more shareholders or proposes a public offering
Maximum Sales Charge
• FINRA cap: 8.5% of the public offering price (POP)
• Applies to mutual fund front-end loads
Prospectus Requirements
• Must be provided at or before the time of purchase
• Contains:
- Investment objectives and strategies
- Risks
- Fees and expenses (fee table)
- Historical performance
- How to buy and redeem shares
Redemption of Shares
• Mutual funds must send redemption proceeds within seven calendar days of receiving the request
• This is known as the "7-day rule"
• Most funds settle much faster (typically T+1 or T+2)
Key Terms
• Investment Company Act of 1940 – Primary regulatory law for investment companies
• SEC registration – Required at 100+ shareholders or public offering
• Prospectus – Required disclosure document provided at/before purchase
• 7-day rule – Redemption proceeds must be sent within 7 calendar days
⚠️ Watch Out For
• The 7-day rule is a maximum — not the typical processing time
• Registration with the SEC is triggered at 100 shareholders, not upon formation
• Always distinguish between the prospectus (required disclosure) and the Statement of Additional Information (SAI) — the SAI is available upon request but not automatically delivered
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5. Fund Characteristics & Features
Diversified vs. Non-Diversified Funds
Diversified Fund must meet the 75-5-10 rule for at least 75% of assets:
• No more than 5% of assets in any one issuer
• Holds no more than 10% of any issuer's voting securities
Non-Diversified Fund:
• Not subject to these restrictions
• Can concentrate holdings — higher potential return but higher risk
Money Market Mutual Funds
• Type of open-end fund
• Invests in short-term, high-quality debt instruments (T-bills, commercial paper, CDs)
• Seeks to maintain a stable NAV of $1.00 per share
• The $1.00 NAV is a goal, not guaranteed — "breaking the buck" is possible but rare
• Subject to SEC Rule 2a-7 (quality, maturity, and diversification requirements)
Key Terms
• Diversified fund – Meets 75-5-10 rule for asset allocation
• Non-diversified fund – No concentration restrictions
• Money market fund – Short-term debt fund targeting $1.00 NAV
• 75-5-10 rule – Diversification standard under the 1940 Act
• Breaking the buck – When a money market fund's NAV falls below $1.00
⚠️ Watch Out For
• The 75-5-10 rule applies to 75% of assets only — the remaining 25% can be concentrated
• Money market funds are not FDIC insured and the $1.00 NAV is not guaranteed
• Don't confuse money market mutual funds with money market bank accounts — they are different products with different protections
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Quick Review Checklist
Use this checklist to confirm your readiness before exam day:
• [ ] Can name and distinguish all three types of investment companies under the 1940 Act
• [ ] Know the difference between open-end and closed-end funds (pricing, redemption, shares)
• [ ] Understand how ETFs differ from mutual funds in terms of trading and pricing
• [ ] Can calculate NAV per share and POP using the correct formulas
• [ ] Understand the forward pricing rule and why it exists
• [ ] Know the characteristics of Class A, B, and C shares and their associated costs
• [ ] Know the 12b-1 fee cap (1% total; 0.75% distribution + 0.25% service)
• [ ] Understand breakpoints, LOIs (13 months, non-binding), and rights of accumulation
• [ ] Know the maximum sales charge allowed by FINRA (8.5% of POP)
• [ ] Understand the 7-day redemption rule
• [ ] Know the 75-5-10 diversification rule and when it applies
• [ ] Understand what a money market fund is and its $1.00 NAV target (not guaranteed)
• [ ] Know what a prospectus must contain and when it must be delivered
• [ ] Recognize the 100-shareholder threshold for SEC registration under the 1940 Act
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Focus especially on NAV/POP calculations, share class differences, breakpoint rules, and the forward pricing rule — these are among the most frequently tested concepts on the SIE Exam.