Before 1924, if you wanted a diversified portfolio of stocks, you needed to be wealthy. Really wealthy. The kind of wealthy where you could afford to buy meaningful positions in dozens of companies while still having enough left over for a reasonable life.
Then something remarkable happened in Boston. The Massachusetts Investors Trust launched on March 21, 1924, becoming what most consider America's first modern mutual fund. The concept was elegantly simple: pool money from many investors, hire a professional to manage it, and suddenly the average person could own a slice of corporate America.
What is an Investment Company?
An investment company does exactly what the name suggests: it's a company that invests. More specifically, it:
- Issues securities to raise capital from investors
- Uses those proceeds to build a portfolio of securities
- Allows investors to own shares of that diversified pool
Think of it as crowdfunding for Wall Street, except it predates that term by about 90 years.
The Investment Company Act of 1940
After the stock market crash of 1929 and the subsequent Great Depression, Congress decided that maybe—just maybe—some regulation of pooled investment vehicles would be prudent. The Investment Company Act of 1940 established the framework we still use today. The 1929 crash exposed serious problems with pooled investments of the era. Many were highly leveraged, charged excessive fees, and lacked transparency.
The Act recognizes three types of investment companies:
Types of Investment Companies
|
┌────────────────────┼────────────────────┐
| | |
Face-Amount Management Company Unit Investment
Certificate | Trust (UIT)
Company | |
┌──────┴──────┐ ┌────┴────┐
| | | |
Open-End Closed-End Fixed Non-Fixed
| | UIT UIT
| | | |
Mutual Fund Publicly Fixed Variable
Traded Trust Annuity
Fund
Face-Amount Certificate Companies are largely historical relics—they promised to pay a fixed sum at maturity if you made periodic payments. Think of them as a hybrid between a savings bond and an annuity. You'll rarely encounter them in practice, but they may appear on your exam.
The other two types are where the action is.
Management Companies
Management companies are actively managed portfolios of securities. A fund manager—called an investment adviser—makes decisions about what to buy and sell based on the fund's investment objective.
This is the key distinction: someone is actively making decisions. Whether those decisions add value after fees is a debate that has launched a thousand academic papers.
Open-End Management Companies – MUTUAL FUNDS
When most people say "mutual fund," they mean an open-end management company. Here's what defines them:
- Can only issue common stock — no bonds or preferred shares
- The number of shares is "open-ended" — the fund creates new shares when investors buy and retires shares when they sell
- Shares are non-negotiable — you can't sell your shares to another investor on an exchange
- Shares are redeemed at the Net Asset Value (NAV) — the fund itself buys back your shares
The "open-ended" nature is crucial. When you invest $10,000 in a mutual fund, the fund creates new shares for you. When you withdraw, those shares disappear. The fund is constantly expanding and contracting.
Closed-End Management Companies – PUBLICLY TRADED FUNDS
Closed-end funds work differently:
- Can issue stocks or bonds
- One-time stock issuance — after the IPO, no new shares are created
- Shares trade on an exchange or OTC — like regular stocks
- Not redeemable — the fund doesn't buy back shares; you sell to another investor
Because closed-end fund shares trade on the open market, they can trade at a premium or discount to their NAV. If a fund holds $100 million in securities but investors are pessimistic about its prospects, it might trade at $95 million (a 5% discount). If investors are enthusiastic, it might trade at $105 million (a 5% premium).
This creates arbitrage opportunities that don't exist with open-end funds—and exam questions that definitely do.
Test Tip: The exam loves to test the differences between open-end and closed-end funds. Remember: open-end = continuous issuance and redemption at NAV; closed-end = one-time issuance, trades on exchange, can trade at premium or discount.
Unit Investment Trusts
Unit Investment Trusts (UITs) take a different approach: they assemble a fixed portfolio and hold it. No active management. No trading. Just... holding.
- Issue shares of beneficial interest representing an undivided interest in the trust
- Have a termination date — the trust eventually winds down
- Have no board of directors — there's a trustee instead
Fixed UIT
The classic UIT:
- Selects a fixed portfolio of unmanaged securities
- Traditionally bonds (hence the "fixed" name)
- Once selected, the portfolio doesn't change
- Matures at a fixed date
If you want to know exactly what you own and don't want anyone tinkering with it, a fixed UIT delivers that certainty.
Non-Fixed UIT
Non-fixed UITs invest in mutual funds, typically within insurance company products:
- Variable Annuities are the primary example
- Use investment companies to provide investment options
- Popular for retirement planning
The "non-fixed" refers to the fact that the underlying mutual funds are actively managed, even though the UIT structure itself is passive.
Key Points to Remember
- Three types of investment companies: Face-amount certificate companies (rare), management companies, and UITs
- Open-end funds: Create and redeem shares continuously at NAV
- Closed-end funds: Fixed number of shares trading on exchanges
- UITs: Fixed portfolio, no active management, have termination dates