What Is an Investment Company?
An investment company is a corporation or trust engaged in the business of investing the pooled capital of investors in financial securities. Types of investment companies are mutual funds, closed-end funds, and unit investment trusts. In the United States, most investment companies are registered with and regulated by the Securities and Exchange Commission (SEC) under the Investment Company Act of 1940.
An investment company may be known as a “fund company” or “fund sponsor.” They often partner with third-party distributors to sell mutual funds.
Key Takeaways
- Investment companies pool capital from investors to invest in a diverse range of securities, such as stocks, bonds, and commodities.
- There are three main types of investment companies: closed-end funds, open-end funds (also known as mutual funds), and unit investment trusts (UITs), each with unique structures and regulations.
- Fees associated with investment companies can impact returns, so investors should carefully review a fund’s prospectus and performance before investing.
- Investment companies are subject to regulations under the Securities Act of 1933 and the Investment Company Act of 1940, which require specific registration, disclosure, and reporting standards.
- Unlike traditional investment companies, private investment funds such as hedge funds and private equity are exempt from these acts but still adhere to other securities laws.
How Investment Companies Operate
Investment companies, both private and public, manage, sell, and market funds to the public. The main business of an investment company is to hold and manage securities for investment purposes, but they typically offer investors a variety of funds and investment services, which include portfolio management, record-keeping, and custodial, legal, accounting, and tax management services.
An investment company can be a corporation, partnership, business trust, or limited liability company (LLC) that pools money from investors on a collective basis. Pooled money is invested, and investors share profits and losses based on their interests. For example, assume an investment company pooled and invested $10 million from a number of clients, who represent the fund company’s shareholders. A client who contributed $1 million will have a vested interest of 10% in the company, which would also translate into any losses or profits earned.
Investment companies are categorized into three types: closed-end funds, mutual funds (or open-end funds), and unit investment trusts (UITs). Each of these three investment companies must register under the Securities Act of 1933 and the Investment Company Act of 1940.
Important
Investment companies may charge fees on their products, including management fees and other expenses, which can reduce returns. Investors should carefully review the fund’s prospectus and performance before investing in a closed-end fund.
Exploring Closed-end Funds
Closed-end funds issue a fixed number of shares that may then be traded on stock exchanges. As demand increases or wanes for fund shares, the supply of them remains the same. Share prices depend on market demand and can trade at a premium or discount to the fund’s net asset value (NAV), though they often start at a discount.
Investors who want to sell shares will sell them to other investors on the secondary market at a price determined by market forces and participants, making them not redeemable. Since investment companies with a closed-end structure issue only a fixed number of shares, back-and-forth trading of the shares in the market has no impact on the portfolio.
An Overview of Mutual Funds and Open-end Funds
Mutual funds have a floating number of issued shares, and investors may sell or redeem their shares back to the fund or the broker acting for the fund at their current net asset value at each trading day’s closing NAV. As investors move their money in and out of the fund, the fund expands and contracts, respectively. Open-end funds are often restricted to investing in liquid assets, given that the investment managers have to plan in a way that the fund is able to meet the demands of investors who may want their money back anytime.
Mutual fund companies charge fees like management and 12b-1 fees, which can reduce returns, though fees have recently decreased. Mutual funds are popular among investors because they can offer diversification and professional management. However, investors should carefully review the fund’s prospectus and performance before investing in a mutual fund.
Understanding Unit Investment Trusts (UITs)
A unit investment trust (UIT) issues fixed units representing interests in a specific portfolio of securities. They terminate on a set date, and investors receive a pro rata share of net assets.
UITs are passive investments in that they typically invest in a fixed portfolio of securities, such as stocks or bonds, and are not actively traded or rebalanced like the portfolios of mutual funds or closed-end funds. UITs may charge fees, including a creation and development fee, a trustee fee, and other expenses, which can reduce returns.
Fast Fact
Each of these fund types can invest in a variety of securities, such as stocks, bonds, and commodities. Some may also use leverage to enhance returns, but this also increases the risk involved.
Is a Hedge Fund an Investment Company?
Private investment funds that only accept money from investors with a substantial amount of assets (i.e., accredited investors) are not considered to be investment companies under federal securities laws. These funds are exempt from the registration requirements under the Investment Company Act of 1940, but they are still subject to other securities laws and regulations. Private investment funds include hedge funds, private equity funds, and venture capital funds.
What Was the First Investment Company?
Investment companies have been around since the 1800s. The first mutual fund, the Massachusetts Investors Trust, was established in 1924 to allow small investors to invest in the stock market. It was an open-end fund, which became the most popular type of investment company. An iteration of this fund operates under the ticker MITTX.
How Can Investment Companies Be Socially Responsible?
Socially responsible investing (SRI) became a growing trend in the investment industry, and some investment companies specialize in SRI strategies. These companies invest in companies that have a positive impact on society and the environment, while avoiding companies that engage in practices that are harmful to people or the planet.
Investment companies can play a role in philanthropy. Donor-advised funds (DAFs) allow individuals to donate money to a charitable organization while still retaining some control over how the funds are invested and distributed. This can be a tax-efficient way to support charitable causes while also benefiting from the investment returns.
The Bottom Line
Investment companies pool capital from investors to invest in diverse securities such as stocks, bonds, and commodities. They operate under strict regulations set by the Securities Act of 1933 and the Investment Company Act of 1940 to ensure transparency and protect investor interests. The three main types of investment companies include closed-end funds, mutual funds (open-end funds), and unit investment trusts (UITs), each offering unique structures and risk profiles.
When considering investment options, investors should thoroughly review offering documents, historical performance, and associated risks for informed decision-making. Despite investment companies offering diversification and professional management, fees such as management or other operating expenses can impact returns, necessitating careful evaluation. Even though mutual funds provide opportunities for diversification, investors should examine associated fees which can potentially reduce returns.
