Chpt 4
Investment Companies
An investment company is a corporation or trust that pools investors' money and then invests that money in securities on their behalf. Investors are able to pool their money and have the investment company invest it based on a clearly defined objective, such as growth or income. By investing these pooled funds as a single large account that is jointly owned by every investor in the company, the investment company is able to invest in many different securities and therefore reduce the overall risk associated with investing in only one or a few. These pooled investments can total hundreds of millions or even billions of dollars. They are very popular investment vehicles because it is common for them to allow minimum investments of only $100 or even less. While investing $100 many times might not purchase a single share of stock or one bond, the ability to pool that $100 with thousands or millions of investors gives the individual investor a great advantage: purchasing power in the marketplace.
Like corporate issuers, investment companies raise capital by selling shares to the public. Investment companies must abide by the same registration and prospectus requirements imposed on other issuers by the Securities Act of 1933. Investment companies are subject to regulations regarding how their shares are sold to the public, and they are regulated by the Investment Company Act of 1940.
Types of Investment Companies
The Investment Company Act of 1940 classifies investment companies into three broad types: face-amount certificate (FAC) companies, unit investment trusts (UITs), and management investment companies.
Face-Amount Certificates (FACs)
A FAC is a contract between an investor and an issuer in which the issuer guarantees payment of a stated (face amount) sum to the investor at some set date in the future. In return for this future payment, the investor agrees to pay the issuer a set amount of money, either as a lump sum or in periodic installments. If the investor pays for the certificate in a lump sum, the investment is known as a fully paid FAC.
Issuers of these investments are FAC companies. Very few FAC companies operate today.
Test Topic Alert
The most important thing to remember about FACs is that they are investment companies as defined under the Investment Company Act of 1940.
Unit Investment Trusts (UITs)
A UIT is an investment company organized under a trust indenture. UITs do not have boards of directors; they have trustees.
UITs create a portfolio of debt or equity securities designed to meet the company's objectives. They then sell redeemable interests—also known as units or shares of beneficial interest—in their portfolio of securities. Each share is an undivided interest in the entire underlying portfolio.
A UIT may be fixed or nonfixed. A debt-fixed UIT typically purchases a portfolio of bonds and terminates when the bonds in the portfolio mature. An equity-fixed UIT purchases a portfolio of stocks and, because stocks don't have a maturity date, terminates at an arbitrary predetermined date. Because a fixed UIT's portfolio is static, there is no need for active management and little or no portfolio turnover. UITs do not generally assess management fees because there is no need to hire an investment adviser to monitor and trade positions within the portfolio. Nonfixed UITs, called contractual plans, purchase shares of an underlying mutual fund. They are nonfixed because the underlying assets (mutual funds) change investments. Nonfixed UITs have not appeared on the exam.
Take Note
FACs and UITs are not managed; once the portfolios are composed, they do not change.
FACs and UITs do not trade in the secondary market; they are redeemable only through the issuer.
Managed Investment Companies (Closed and Open End)
The most familiar type of investment company is the managed investment company, which actively manages a securities portfolio to achieve a stated investment objective. A managed investment company is either closed end or open end. Both closed- and open-end companies sell shares to the public in an initial public offering (IPO); the primary difference between them is that a closed-end company's initial offering of shares is limited (it closes after a specific authorized number of shares have been sold) and an open-end company is perpetually offering new shares to the public (it is continually open to new investors). In this section, we'll look at each:
Closed-end investment companies. A closed-end company will raise capital for its portfolio by conducting a common stock offering, much like any other publicly traded company that raises capital to invest in its business. In the initial offering, the company registers a fixed number of shares with the Securities and Exchange Commission (SEC) and offers them to the public with a prospectus for a limited time through underwriters. Once all the shares have been sold, the fund is closed to new investors. Many times, a fund elects to be a closed-end company because the sector in which it intends to invest has a limited number of securities available. Closed-end investment companies may also issue bonds and preferred stock. Closed-end investment companies are often called publicly traded funds. After the stock is sold in the initial offering, anyone can buy or sell shares in the secondary market [i.e., on an exchange or over the counter (OTC)] in transactions between private investors. Supply and demand determine the bid price (price at which an investor can sell) and the ask price (price at which an investor can buy). Closed-end fund shares may trade above (at a premium to) or below (at a discount to) the shares' net asset value (NAV). Simply put, the fund's NAV is its assets minus its liabilities. The NAV per share is the fund's NAV divided by the number of outstanding shares. NAV is covered in more detail later in this unit
Test Topic Alert
Closed-end investment companies may issue common stock, preferred stock, and debt securities.
Open-end investment companies (mutual funds). An open-end company only issues one class of security, which is common stock (no preferred shares or bonds). It does not specify the exact number of shares it intends to issue but registers an open offering with the SEC. In other words, mutual funds conduct a continuous primary offering of common stock. With this registration type, they can raise an unlimited amount of investment capital by continuously issuing new shares. When investors want to sell their holdings in a mutual fund, the fund itself redeems those shares at the fund's current NAV, discussed shortly. In this respect, mutual fund shares are like FACs and UITs in that they do not trade in the secondary market. When an investor sells shares back to the fund (the fund is redeeming the shares), the fund sends the investor money for the investor's proportionate share of the fund's net assets. Therefore, a mutual fund's capital shrinks when investors redeem shares, but so does the number of outstanding shares; the value of each share does not fall as a result of the redemption. When a client acquires mutual fund shares, she pays the current public offering price (POP). Mutual funds are priced at the end of each business day, with sellers receiving the next calculated NAV and buyers paying the next calculated POP. All transition requests must be entered by 4:00 pm ET. Any requests to buy or sell that are entered after 4:00 pm will receive the next business day's NAV or POP. For example, a seller who places an order after the close (4:00 pm ET) on Friday will receive Monday's NAV when liquidating her shares.
Take Note
You should understand that while mutual funds only issue common shares to their shareholders, the funds themselves can purchase common stock, preferred stock, and bonds for their investment portfolios. As noted, each fund has a stated investment objective, and which types of securities the fund portfolio purchases has largely to do with fulfilling that objective.
Take Note
There are other types of open-end management companies besides mutual funds. However, most test questions on the topic are based on mutual funds.