The investment company concept dates to the late 1700s in Europe, according to K. Geert Rouwenhorst in The Origins of Mutual Funds, when “a Dutch merchant and broker…invited subscriptions from investors to form a trust…to provide an opportunity to diversify for small investors with limited means.”
The emergence of “investment pooling” in England in the 1800s brought the concept closer to U.S. shores. In 1868, the Foreign and Colonial Government Trust formed in London. This trust resembled the U.S. fund model in basic structure, providing “the investor of moderate means the same advantages as the large capitalists…by spreading the investment over a number of different stocks.”
Perhaps more importantly, the British fund model established a direct link with U.S. securities markets, helping to finance the development of the post–Civil War U.S. economy. The Scottish American Investment Trust, formed on February 1, 1873, by fund pioneer Robert Fleming, invested in the economic potential of the United States, chiefly through American railroad bonds. Many other trusts followed that not only targeted investment in America, but also led to the introduction of the fund investing concept on U.S. shores in the late 1800s and early 1900s.
The first mutual, or “open-end,” fund was introduced in Boston in March 1924. The Massachusetts Investors Trust introduced important innovations to the investment company concept by establishing a simplified capital structure, continuous offering of shares, the ability to redeem shares rather than hold them until dissolution of the fund, and a set of clear investment restrictions and policies.
The stock market crash of 1929 and the Great Depression that followed hampered the growth of pooled investments until a succession of landmark securities laws, beginning with the Securities Act of 1933 and concluding with the Investment Company Act of 1940, reinvigorated investor confidence. Renewed investor confidence and many innovations led to relatively steady growth in industry assets and number of accounts.
Four Principal Securities Laws Govern Investment Companies
|The Investment Company Act of 1940||Regulates the structure and operations of investment companies through a combination of disclosure requirements and restrictions on day-to-day operations. Among other things, the Investment Company Act addresses investment company capital structures, custody of assets, investment activities (particularly with respect to transactions with affiliates and other transactions involving potential conflicts of interest), and the duties of fund boards.|
|The Investment Advisers Act of 1940||Regulates investment advisers. Requires all advisers to registered investment companies and other large advisers to register with the SEC. The Advisers Act contains provisions requiring fund advisers to meet recordkeeping, custodial, reporting, and other regulatory responsibilities.|
|The Securities Exchange Act of 1934||Regulates the trading, purchase, and sale of securities, including investment company shares. The 1934 Act also regulates broker-dealers, including investment company principal underwriters and others that sell investment company shares, and requires them to register with the SEC.|
|The Securities Act of 1933||Regulates public offerings of securities, including investment company shares. The 1933 Act also requires that all investors receive a current prospectus describing the fund.|
Fund sponsors in the United States offer four types of registered investment companies: open-end investment companies (commonly called mutual funds), closed-end investment companies, exchange-traded funds (ETFs), and unit investment trusts (UITs).
The vast majority of investment companies are mutual funds, both in terms of number of funds and assets under management. Mutual funds can have actively managed portfolios, in which a professional investment adviser creates a unique mix of investments to meet a particular investment objective, or passively managed portfolios, in which the adviser seeks to track the performance of a selected benchmark or index. One hallmark of mutual funds is that they issue redeemable securities, meaning that the fund stands ready to buy back its shares at their current net asset value (NAV). The NAV is calculated by dividing the total market value of the fund’s assets, minus its liabilities, by the number of mutual fund shares outstanding.
Money market funds are one type of mutual fund; a defining feature of money market funds is that they seek to maintain a stable NAV. Money market funds offer investors a variety of features, including liquidity, a market-based rate of return, and the goal of returning principal, all at a reasonable cost. These funds are registered investment companies that are regulated by the Securities and Exchange Commission (SEC) under U.S. federal securities laws, including Rule 2a-7 under the Investment Company Act. That rule, which was substantially enhanced in 2010, contains numerous risk-limiting conditions intended to help a fund achieve the objective of maintaining a stable NAV using amortized cost accounting or penny rounding or both. Typically money market fund shares are publicly offered to all types of investors.
Unlike mutual funds, closed-end funds do not issue redeemable shares. Instead, they issue a fixed number of shares that trade intraday on stock exchanges at market-determined prices. Investors in a closed-end fund buy or sell shares through a broker, just as they would trade the shares of any publicly traded company. For more information on closed-end funds, see chapter 4.
ETFs are described as a hybrid of other types of investment companies. They are structured and legally classified as mutual funds or UITs (discussed below), but trade intraday on stock exchanges like closed-end funds. ETFs only buy and sell fund shares directly to authorized participants in large blocks, often 50,000 shares or more. For more information on ETFs, see chapter 3.
UITs are also a hybrid, with some characteristics of mutual funds and some of closed-end funds. Like closed-end funds, UITs typically issue only a specific, fixed number of shares, called “units.” Like mutual funds, the units are redeemable, but unlike mutual funds, generally the UIT sponsor will maintain a secondary market in the units so that redemptions do not deplete the UIT’s assets. A UIT does not actively trade its investment portfolio, instead buying and holding a set of particular investments until a set termination date, at which time the trust is dissolved and proceeds are paid to shareholders. For more information on UITs, see chapter 1.
A mutual fund typically is organized under state law either as a corporation or a business trust (sometimes called a statutory trust). The three most popular forms of organization are Massachusetts business trusts, Maryland corporations, and Delaware statutory trusts (Figure A.1).1
1More than 1,000 funds, or about 11 percent, have chosen other forms of organization, such as limited liability partnerships, or other domiciles, such as Ohio or Minnesota.
Massachusetts business trusts are the most popular of these trusts, largely as a result of history. The very first mutual fund was formed as a Massachusetts business trust, which was a popular form of organization at the time for pools that invested in real estate or public utilities. That fund, the Massachusetts Investors Trust, provided a model for other funds to follow, leading to widespread use of Massachusetts business trusts throughout much of the industry’s early history. Developments in the late 1980s gave asset management companies other attractive choices. In 1987, Maryland amended its corporate statute to align with interpretations of the Investment Company Act of 1940 concerning when funds are required to hold annual meetings, thereby making a Maryland corporation more competitive with the Massachusetts business trust as a form of organization for mutual funds. In 1988, Delaware—already a popular domicile for U.S. corporations—adopted new statutory provisions devoted specifically to business trusts (since renamed statutory trusts). As a result of these developments, many mutual funds created in the last 25 years have been organized as Maryland corporations or Delaware statutory trusts.
The Most Popular Forms of Mutual Fund Organization
Percentage of funds, year-end 2012
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Note: Data include mutual funds that do not report statistical information to the Investment CompanyInstitute. Data also include mutual funds that invest primarily in other mutual funds.
Mutual funds have officers and directors (if the fund is a corporation) or trustees (if the fund is a business trust).2 The fund’s board plays an important role, described in more detail in Oversight and Accountability.
2For ease of reference, this appendix refers to all directors and trustees as directors and all boards as boards of directors.
Unlike other companies, a mutual fund is typically externally managed; it is not an operating company and it has no employees in the traditional sense. Instead, a fund relies upon third parties or service providers—either affiliated organizations or independent contractors—to invest fund assets and carry out other business activities. Figure A.2 shows the primary types of service providers usually relied upon by a fund.
Although it typically has no employees, a fund is required by law to have its own written compliance program, overseen by an individual designated as a chief compliance officer (CCO). This compliance program establishes detailed procedures and internal controls designed to ensure compliance with all relevant laws and regulations.
Organization of a Mutual Fund
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Like shareholders of other companies, mutual fund shareholders have specific voting rights. These include the right to elect directors at meetings called for that purpose and the right to approve material changes in the terms of a fund’s contract with its investment adviser, the entity that manages the fund’s assets. For example, a fund’s management fee cannot be increased and a fund’s investment objectives or fundamental policies cannot be changed unless a majority of shareholders vote to approve the increase or change.
Setting up a mutual fund is a complicated process performed by the fund’s sponsor, which is typically the fund’s investment adviser. The fund sponsor has a variety of responsibilities. For example, it must assemble the group of third parties needed to launch the fund, including the persons or entities charged with managing and operating the fund. The sponsor provides officers and affiliated directors to oversee the fund and recruits unaffiliated persons to serve as independent directors.
Some of the major steps in the process of starting a mutual fund include organizing the fund under state law, registering the fund with the SEC as an investment company pursuant to the Investment Company Act of 1940, and registering the fund shares for sale to the public pursuant to the Securities Act of 1933.3 Unless otherwise exempt from doing so, the fund also must make filings and pay fees to each state (except Florida) in which the fund’s shares will be offered to the public. The Investment Company Act also requires that each new fund have at least $100,000 of seed capital before distributing its shares to the public; this capital is usually contributed by the sponsor or adviser in the form of an initial investment.
3For more information on the requirements for the initial registration of a mutual fund, see the SEC’s Investment Company Registration and Regulation Package, available at www.sec.gov/divisions/investment/invcoreg121504.htm.
Investment advisers have overall responsibility for directing the fund’s investments and handling its business affairs. The investment advisers have their own employees, including investment professionals who work on behalf of the fund’s shareholders and determine which securities to buy and sell in the fund’s portfolio, consistent with the fund’s investment objectives and policies. In addition to managing the fund’s portfolio, the adviser often serves as administrator to the fund, providing various “back-office” services. As noted earlier, a fund’s investment adviser is often the fund’s initial sponsor and its initial shareholder through the seed money invested to create the fund.
To protect investors, a fund’s investment adviser and the adviser’s employees are subject to numerous standards and legal restrictions, including restrictions on transactions that may pose conflicts of interest. Like the mutual fund, investment advisers are required to have their own written compliance programs that are overseen by CCOs and establish detailed procedures and internal controls designed to ensure compliance with all relevant laws and regulations.
A fund’s administrator handles the many back-office functions for a fund. For example, administrators often provide office space, clerical and fund accounting services, data processing, bookkeeping and internal auditing, and prepare and file SEC, tax, shareholder, and other reports. Fund administrators also help maintain compliance procedures and internal controls, subject to oversight by the fund’s board and CCO.
Investors buy and redeem fund shares either directly or indirectly through the principal underwriter, also known as the fund’s distributor. Principal underwriters are registered under the Securities Exchange Act of 1934 as broker-dealers, and, as such, are subject to strict rules governing how they offer and sell securities to investors.
The principal underwriter contracts with the fund to purchase and then resell fund shares to the public. A majority of both the fund’s independent directors and the entire fund board must approve the contract with the principal underwriter.
Mutual funds and their shareholders rely on the services of transfer agents to maintain records of shareholder accounts, calculate and distribute dividends and capital gains, and prepare and mail shareholder account statements, federal income tax information, and other shareholder notices. Some transfer agents also prepare and mail statements confirming shareholder transactions and account balances. They also may maintain customer service departments, including call centers, to respond to shareholder inquiries.
Auditors certify the fund’s financial statements. The auditors’ oversight role is described more fully below.
Mutual funds are subject to special tax rules set forth in subchapter M of the Internal Revenue Code. Unlike most corporations, mutual funds are not subject to taxation on their income or capital gains at the entity level, provided that they meet certain gross income, asset, and distribution requirements.
To qualify as a regulated investment company (RIC) under subchapter M, at least 90 percent of a mutual fund’s gross income must be derived from certain sources, including dividends, interest, payments with respect to securities loans, and gains from the sale or other disposition of stock, securities, or foreign currencies. In addition, at the close of each quarter of the fund’s taxable year, at least 50 percent of the value of the fund’s total net assets must consist of cash, cash items, government securities, securities of other funds, and investments in other securities which, with respect to any one issuer, represent neither more than 5 percent of the assets of the fund nor more than 10 percent of the voting securities of the issuer. Further, no more than 25 percent of the fund’s assets may be invested in the securities of any one issuer (other than government securities or the securities of other funds), the securities (other than the securities of other funds) of two or more issuers which the fund controls and are engaged in similar trades or businesses, or the securities of one or more qualified publicly traded partnerships.
If a mutual fund satisfies the gross income and asset tests and thus qualifies as a RIC, the fund is not subject to tax on its income and capital gains, provided that the RIC distributes at least 90 percent of its income (other than net capital gains) each year. A RIC may retain up to 10 percent of its income and all capital gains, but the retained income is taxed at regular corporate tax rates. Therefore, mutual funds generally distribute nearly all of their income and capital gains each year.
The Internal Revenue Code also imposes an excise tax on RICs, unless a RIC distributes by December 31 at least 98 percent of its ordinary income earned during the calendar year, and 98 percent of its net capital gains earned during the 12-month period ending on October 31 of the calendar year. Mutual funds typically seek to avoid this charge—imposed at a 4 percent rate on the “underdistributed” amount—by electing to distribute their income each year.
Mutual Fund Assets by Tax Status
Mutual funds generally distribute all earnings—capital gains and ordinary dividends—each year to shareholders, and are taxed only on amounts retained. Fund investors are ultimately responsible for paying tax on a fund’s earnings, whether they receive the distributions in cash or reinvest them in additional fund shares. Investors often attempt to lessen the impact of taxes on their investments by investing in tax-exempt funds and tax-deferred retirement accounts and variable annuities. As of year-end 2012, 7 percent of all mutual fund assets were held in tax-exempt funds, and 49 percent were invested in tax-deferred accounts held by households.
56 Percent of Mutual Fund Total Net Assets Were Held in Tax-Deferred Accounts and Tax-Exempt Funds
Percentage of assets, year-end 2012
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Types of Distributions
Mutual funds make two types of taxable distributions to shareholders: ordinary dividends and capital gains.
Dividend distributions come primarily from the interest and dividends earned by the securities in a fund’s portfolio and net short-term gains, if any, after expenses are paid by the fund. These distributions must be reported as dividends on an investor’s tax return and are taxed at the investor’s ordinary income tax rate. Legislation in effect through 2012 provided a top tax rate of 15 percent on certain “qualified dividend” income. Some dividends paid by mutual funds may qualify for this lower tax rate.
Long-term capital gains distributions represent a fund’s net gains, if any, from the sale of securities held in its portfolio for more than one year. Legislation in effect through 2012 also provided a top tax rate of 15 percent on investors’ long-term capital gains; a lower rate applies to some taxpayers.
Fund investors ultimately are responsible for paying tax on their share of a fund’s earnings, whether they receive the distributions in cash or reinvest them in additional fund shares. To help mutual fund shareholders understand the impact of taxes on the returns generated by their investments, the SEC requires mutual funds to disclose standardized after-tax returns for one-, five-, and 10‑year periods. After-tax returns, which accompany before-tax returns in fund prospectuses, are presented in two ways:
- After taxes on fund distributions only (preliquidation)
- After taxes on fund distributions and an assumed redemption of fund shares (postliquidation)
Types of Taxable Shareholder Transactions
An investor who sells mutual fund shares usually incurs a capital gain or loss in the year the shares are sold; an exchange of shares between funds in the same fund family also results in either a capital gain or loss.
Investors are liable for tax on any capital gain arising from the sale of fund shares, just as they would be if they sold a stock, bond, or other security. Capital losses from mutual fund share sales and exchanges, like capital losses from other investments, may be used to offset other capital gains in the current year and thereafter.
Mutual Fund Dividend Distributions
Dividend distributions represent income—primarily from interest and dividends earned by securities in a fund’s portfolio—after expenses are paid by the fund. Mutual funds distributed $225 billion in dividends to fund shareholders in 2012 (Figure A.4). Bond and money market funds accounted for 52 percent of all dividend distributions in 2012. Fifty-six percent of all dividend distributions were paid to tax-exempt fund shareholders and tax-deferred household accounts. Another 39 percent were paid to taxable household accounts.
Billions of dollars, 1998–2012
and tax-exempt funds
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Note: Components may not add to the total because of rounding.
Mutual Fund Capital Gains Distributions
Capital gains distributions represent a fund’s net gains, if any, from the sale of securities held in its portfolio. When gains from these sales exceed losses, they are distributed to fund shareholders. Mutual funds distributed $99 billion in capital gains to shareholders in 2012 (Figure A.5). Fifty-six percent of these distributions were paid to tax-deferred household accounts, and another 39 percent were paid to taxable household accounts. Equity, bond, and hybrid funds can distribute capital gains, but equity funds typically account for the bulk of distributions. In 2012, 30 percent of stock fund share classes made a capital gains distribution, and more than 60 percent of these share classes distributed more than 2.0 percent of their assets as capital gains.
Capital Gains Distributions*
Billions of dollars, 1998–2012
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* Capital gains distributions include long-term and short-term capital gains.
Note: Components may not add to the total because of rounding.
The amount of a shareholder’s gain or loss on fund shares is determined by the difference between the “cost basis” of the shares (generally, the purchase price—including sales loads—of the shares, whether acquired with cash or reinvested dividends) and the sale price. Many funds voluntarily provide cost basis information to shareholders or compute gains and losses for shares sold. In 2012, new tax rules required all brokers and funds to provide cost basis information to shareholders, as well as to indicate whether any gains or losses are long-term or short-term, for fund shares acquired on or after January 2, 2012.
Tax-exempt bond funds pay dividends earned from municipal bond interest. This income is exempt from federal income tax and, in some cases, state and local taxes. Tax-exempt money market funds invest in short-term municipal securities or equivalent instruments and also pay exempt-interest dividends. Even though income from these funds generally is tax-exempt, investors must report it on their income tax returns. Tax-exempt funds provide investors with this information and typically explain how to handle tax-exempt dividends on a state-by-state basis. For some taxpayers, portions of income earned by tax-exempt funds also may be subject to the federal alternative minimum tax.
Embedded in the structure and regulation of mutual funds and other registered investment companies are several core principles that provide important protections for shareholders.
Funds are subject to more extensive disclosure requirements than any other comparable financial product, such as separately managed accounts, collective investment trusts, and private pools. The cornerstone of the disclosure regime for mutual funds and ETFs is the prospectus.4 Mutual funds and ETFs are required to maintain a current prospectus, which provides investors with information about the fund, including its investment objectives, investment strategies, risks, fees and expenses, and performance, as well as how to purchase, redeem, and exchange fund shares. Importantly, the key parts of this disclosure with respect to performance information and fees and expenses are standardized to facilitate comparisons by investors. Mutual funds and ETFs may provide investors with a “summary prospectus” containing key information about the fund, while making more information available on the Internet and on paper upon request.
4Closed-end funds and UITs also provide investors with extensive disclosure, but under a slightly different regime that reflects the way shares of these funds trade. Both closed-end funds and UITs file an initial registration statement with the SEC, containing a prospectus and other information related to the initial offering of their shares to the public.
Mutual funds and ETFs also are required to make statements of additional information (SAIs) available to investors upon request and without charge. The SAI conveys information about the fund that, while useful to some investors, is not necessarily needed to make an informed investment decision. For example, the SAI generally includes information about the history of the fund, offers detailed disclosure on certain investment policies (such as borrowing and concentration policies), and lists officers, directors, and other persons who control the fund.
The prospectus, SAI, and certain other required information are contained in the fund’s registration statement, which is filed electronically with the SEC and is publicly available via the SEC’s Electronic Data Gathering, Analysis, and Retrieval (EDGAR) system. Mutual fund and ETF registration statements are amended at least once each year to ensure that financial statements and other information do not become stale.5 These funds also amend registration statements throughout the year as necessary to reflect material changes to their disclosure.
In addition to registration statement disclosure, funds provide shareholders with several other disclosure documents. Shareholders receive audited annual and unaudited semiannual reports within 60 days after the end and the midpoint of the fund’s fiscal year. These reports contain updated financial statements, a list of the fund’s portfolio securities,6 management’s discussion of financial performance, and other information current as of the date of the report.
5Section 10(a)(3) of the Securities Act of 1933 prohibits investment companies that make a continuous offering of shares from using a registration statement with financial information that is more than 16 months old. This gives mutual funds and ETFs four months after the end of their fiscal year to amend their registration statements.
6A fund is permitted to include a summary portfolio schedule in its shareholder reports in lieu of the complete schedule, provided that the complete portfolio schedule is filed with the SEC and is provided to shareholders upon request, free of charge. The summary portfolio schedule includes each of the fund’s 50 largest holdings in unaffiliated issuers and each investment that exceeds 1 percent of the fund’s NAV.
Following their first and third quarter, funds file an additional form with the SEC, Form N-Q, disclosing the complete schedule of their portfolio holdings. Finally, funds annually disclose how they voted on specific proxy issues at portfolio companies on Form N-PX. Funds are the only shareholders required to publicly disclose each and every proxy vote they cast. Funds are not required to mail Form N-Q and Form N-PX to shareholders, but the forms are publicly available via the SEC’s EDGAR database.
The combination of prospectuses, SAIs, annual and semiannual shareholder reports, Form N-Qs, and Form N-PXs provide the investing public, regulators, media, and other interested parties with far more information on funds than is available for other types of investments. This information is easily and readily available from most funds and the SEC. It is also available from any number of private-sector vendors, such as Morningstar, that are in the business of compiling publicly available information on funds in ways that might benefit investors.
Daily Valuation and Liquidity
Nearly all funds offer shareholders liquidity and objective, market-based valuation of their investments at least daily. ETF and closed-end fund shares are traded intraday on stock exchanges at market-determined prices, giving shareholders real-time liquidity and pricing. Mutual fund shares are redeemable on a daily basis at a price that reflects the current market value of the fund’s portfolio securities, calculated according to pricing methodologies established by each fund’s board of directors. The value of each security in the fund’s portfolio is determined either by a market quotation, if a market quotation is readily available, or at fair value as determined in good faith.
The daily pricing process is a critically important core compliance function that involves numerous staff, the fund board, and pricing vendors. The fair valuation process, a part of the overall pricing process, receives particular scrutiny from funds, their boards of directors, regulators, and independent auditors. Under SEC rules, all funds must adopt written policies and procedures that address the circumstances under which securities may be fair valued, and must establish criteria for determining how to assign fair values in particular instances.7
This daily valuation process results in a NAV for the fund. The NAV is the price used for all mutual fund share transactions—new purchases, sales (redemptions), and exchanges from one fund to another within the same fund family.8 It represents the current mark-to-market value of all the fund’s assets, minus liabilities (e.g., fund expenses), divided by the total number of outstanding shares. Mutual funds release their daily NAVs to investors and others after they complete the pricing process, generally around 6:00 p.m. eastern time. Daily fund prices are available through fund toll-free telephone services, websites, and other means.
The Investment Company Act of 1940 requires mutual funds to process transactions based upon “forward pricing,” meaning that shareholders receive the next computed NAV following the fund’s receipt of their transaction order. For example, for a fund that prices its shares at 4:00 p.m.,9 orders received prior to 4:00 p.m. receive the NAV determined that same day at 4:00 p.m. Orders received after 4:00 p.m. receive the NAV determined at 4:00 p.m. on the next business day. Forward pricing is an important protection for mutual fund shareholders. It is designed to minimize the ability of shareholders to take advantage of fluctuations in the price of the securities in the fund’s portfolio that occur after the fund calculates its NAV.
7ICI has published several papers on the mutual fund valuation process. For more information, see ICI’s two white papers titled Valuation and Liquidity Issues for Mutual Funds (February 1997 and March 2002) and two installments of ICI’s Fair Value Series,
“An Introduction to Fair Valuation” (2005) and “The Role of the Board” (2007).
8The pricing process is also critical for ETFs, although for slightly different reasons. ETFs operate like mutual funds with respect to transactions with “authorized participants” who trade with the ETF in large blocks, often of 50,000 shares or more. The NAV is the price used for these large transactions. Closed-end funds are not required to strike a daily NAV, but most do so in order to provide the market with the ability to calculate the difference between the fund’s market price and its NAV. That difference is called the fund’s “premium” or “discount.”
9Funds must price their shares at least once per day at a time determined by the fund’s board. Many funds price at 4:00 p.m. eastern time or when the New York Stock Exchange closes.
When a shareholder redeems shares in a mutual fund, he or she can expect to be paid promptly. Mutual funds may not suspend redemptions of their shares (subject to certain extremely limited exceptions)10 or delay payments of redemption proceeds for more than seven days.
SEC guidelines require a mutual fund to have at least 85 percent of its assets in liquid securities.11 In part to ensure that redemptions can be made, a security is generally deemed to be liquid if it can be sold or disposed of in the ordinary course of business within seven days at approximately the price at which the mutual fund has valued it. Many funds adopt a specific policy with respect to investments in illiquid securities; these policies are sometimes more restrictive than the SEC requirements.
10An example of such an exception would be an emergency that affects markets or funds, such as the assassination of President John F. Kennedy in 1963, the blackouts that affected lower Manhattan in 1990, or earthquakes and other natural disasters. The SEC must declare an emergency to trigger an exception.
11Money market funds are held to a stricter standard, and must limit illiquid investments to 5 percent of the portfolio.
All funds are subject to a strong system of oversight from both internal and external sources. Internal oversight mechanisms include boards of directors, which include independent directors, and written compliance programs overseen by CCOs, both at the fund and adviser levels. External oversight is provided by the SEC, the Financial Industry Regulatory Association (FINRA), and external service providers, such as certified public accounting firms.
Mutual funds, closed-end funds, and most ETFs have boards. The role of a fund’s board of directors is primarily one of oversight. The board of directors typically is not involved in the day-to-day management of the fund company. Instead, day-to-day management is handled by the fund’s investment adviser or administrator pursuant to a contract with the fund.
Investment company directors review and approve major contracts with service providers (including, notably, the fund’s investment adviser), approve policies and procedures to ensure the fund’s compliance with the federal securities laws, and undertake oversight and review of the performance of the fund’s operations. Directors devote substantial time and consider large amounts of information in fulfilling these duties, in part because they must perform all their duties in “an informed and deliberate manner.”
Fund boards must maintain a particular level of independence. The Investment Company Act of 1940 requires at least 40 percent of the members of a fund board to be independent from fund management. An independent director is a fund director who does not have any significant business relationship with a mutual fund’s adviser or underwriter. In practice, most fund boards have far higher percentages of independent directors. As of year-end 2011, independent directors made up three-quarters of boards in approximately 90 percent of fund complexes.12
12See Overview of Fund Governance Practices, 1994–2010 for a description of the study that collects data on this and other governance practices. Available at www.idc.org/pdf/pub_11_fund_governance.pdf.
Independent fund directors play a critical role in overseeing fund operations and are entrusted with the primary responsibility for looking after the interests of the fund’s shareholders. They serve as “watchdogs,” furnishing an independent check on the management of funds. Like directors of operating companies, they owe shareholders the duties of loyalty and care under state law. But independent fund directors also have specific statutory and regulatory responsibilities under the Investment Company Act beyond the duties required of other types of directors. Among other things, for example, they oversee the performance of the fund, approve the fees paid to the investment adviser for its services, and oversee the fund’s compliance program.
The internal oversight function played by the board has been greatly enhanced in recent years by the development of written compliance programs and a formal requirement that all funds have CCOs. Rules adopted in 2003 require every fund and adviser to have a CCO who administers a written compliance program reasonably designed to prevent, detect, and correct violations of the federal securities laws. Compliance programs must be reviewed at least annually for their adequacy and effectiveness, and fund CCOs are required to report directly to the independent directors.
Internal oversight is accompanied by a number of forms of external oversight and accountability. Funds are subject to inspections, examinations, and enforcement by their primary regulator, the SEC. Funds are also overseen by self-regulatory organizations, such as FINRA and stock exchanges; state securities regulators; and banking regulators (to the extent the fund is affiliated with a bank).
A fund’s financial statement disclosure is also subject to several internal and external checks. For example, annual reports include audited financial statements certified by a certified public accounting firm subject to oversight by the Public Company Accounting Oversight Board (PCAOB). This ensures that the financial statements are prepared in conformity with generally accepted accounting principles (GAAP) and present fairly the fund’s financial position and results of operations.
Like officers of public companies, fund officers are required to make certifications and disclosures required by the Sarbanes-Oxley Act. For example, they must certify the accuracy of the financial statements.
Additional Regulation of Advisers
In addition to the system of oversight applicable directly to funds, investors enjoy protections through SEC regulation of the investment advisers that manage fund portfolios. All advisers to registered funds are required to register with the SEC, and are subject to SEC oversight and disclosure requirements. Advisers also owe a fiduciary duty to each fund they advise, meaning that they have a fundamental legal obligation to act in the best interests of the fund pursuant to a duty of undivided loyalty and utmost good faith.
Limits on Leverage
The inherent nature of a fund—a professionally managed pool of securities owned pro rata by its investors—is straightforward and easily understood by investors. The Investment Company Act of 1940 fosters simplicity by prohibiting complex capital structures and limiting funds’ use of leverage.
The Investment Company Act imposes various requirements on the capital structure of mutual funds, closed-end funds, and ETFs, including limitations on the issuance of “senior securities” and borrowing. These limitations greatly minimize the possibility that a fund’s liabilities will exceed the value of its assets.
Generally speaking, a senior security is any debt that takes priority over the fund’s shares, such as a loan or preferred stock. The SEC has historically interpreted the definition of senior security broadly, taking the view that selling securities short, purchasing securities on margin, and investing in many types of derivative instruments, among other practices, may create senior securities.
The SEC also takes the view that the Investment Company Act prohibits a fund from creating a future obligation to pay unless it “covers” the obligation. A fund generally can cover an obligation by owning the instrument underlying that obligation. For example, a fund that wants to take a short position in a certain stock can comply with the Investment Company Act by owning an equivalent long position in that stock. The fund also can cover by earmarking or segregating liquid securities equal in value to the fund’s potential exposure from the leveraged transaction. The assets set aside to cover the potential future obligation must be liquid, unencumbered, and marked-to-market daily. They may not be used to cover other obligations and, if disposed of, must be replaced.
The Investment Company Act also limits borrowing. With the exception of certain privately arranged loans and temporary loans, any promissory note or other indebtedness would generally be considered a prohibited senior security.13 Mutual funds and ETFs are permitted to borrow from a bank if, immediately after the bank borrowing, the fund’s total net assets are at least three times total aggregate borrowings. In other words, the fund must have at least 300 percent asset coverage.
13Temporary loans cannot exceed 5 percent of the fund’s total net assets and must be repaid within 60 days.
Closed-end funds have a slightly different set of limitations. They are permitted to issue debt and preferred stock, subject to certain conditions, including asset coverage requirements of 300 percent for debt and 200 percent for preferred stock.
Many funds voluntarily go beyond the prohibitions in the Investment Company Act, adopting policies that further restrict their ability to issue senior securities or borrow. Funds often, for example, adopt a policy stating that they will borrow only as a temporary measure for extraordinary or emergency purposes and not to finance investment in securities. In addition, they may disclose that, in any event, borrowings will be limited to a small percentage of fund assets (such as 5 percent). These are meaningful voluntary measures, because under the Investment Company Act, a fund’s policies on borrowing money and issuing senior securities cannot be changed without the approval of fund shareholders.
To protect fund assets, the Investment Company Act requires all funds to maintain strict custody of fund assets, separate from the assets of the adviser. Although the Act permits other arrangements,14 nearly all funds use a bank custodian for domestic securities. International securities are required to be held in the custody of an international bank or securities depository.
A fund’s custody agreement with a bank is typically far more elaborate than the arrangements used for other bank clients. The custodian’s services generally include safekeeping and accounting for the fund’s assets, settling securities transactions, receiving dividends and interest, providing foreign exchange services, paying fund expenses, reporting failed trades, reporting cash transactions, monitoring corporate actions at portfolio companies, and tracing loaned securities.
The strict rules on the custody and reconciliation of fund assets are designed to prevent the types of theft and other fraud-based losses that have occurred in less-regulated investment products.15Shareholders are further insulated from these types of losses by a provision in the Investment Company Act that requires all mutual funds to have fidelity bonds designed to protect them against possible instances of employee larceny or embezzlement.
14The Investment Company Act contains six separate custody rules for the different types of possible custody arrangements for mutual funds, closed-end funds, and ETFs. UITs are subject to a separate rule that requires the use of a bank to maintain custody.
15Ponzi schemes and other frauds involving the misappropriation of assets in unregistered pools or private accounts have comprised a significant portion of SEC enforcement cases in recent years.
Prohibitions on Transactions with Affiliates
The Investment Company Act of 1940 contains a number of strong and detailed prohibitions on transactions between the fund and fund insiders or affiliated organizations (such as the corporate parent of the fund’s adviser). Many of these prohibitions were part of the original statutory text of the Act, enacted in response to instances of overreaching and self-dealing by fund insiders during the 1920s in the purchase and sale of portfolio securities, loans by funds, and investments in related funds. The SEC’s Division of Investment Management has said that “for more than 50 years, [the affiliated transaction prohibitions] have played a vital role in protecting the interests of shareholders and in preserving the industry’s reputation for integrity; they continue to be among the most important of the Act’s many protections.”16
Although there are a number of affiliated transaction prohibitions in the Investment Company Act, three are particularly noteworthy:
- Generally prohibiting direct transactions between a fund and an affiliate
- Generally prohibiting joint transactions, where the fund and affiliate are acting together vis-à-vis a third party
- Preventing investment banks from placing or “dumping” unmarketable securities with an affiliated fund by generally prohibiting the fund from buying securities in an offering syndicated by an affiliated investment bank
16See Protecting Investors: A Half Century of Investment Company Regulation, Report of the Division of Investment Management, Securities and Exchange Commission (May 1992), available at www.sec.gov/divisions/investment/guidance/icreg50-92.pdf. The Division of Investment Management is the division within the SEC responsible for the regulation of funds.
Both tax law and the Investment Company Act provide diversification standards for funds. As discussed in detail above, under the tax laws, all mutual funds, closed-end funds, and ETFs, as well as most UITs, qualify as RICs and, as such, must meet a tax diversification test every quarter. The effect of this test is that a fund with a modest cash position and no government securities would hold securities from at least 12 different issuers. Another tax diversification restriction limits the amount of an issuer’s outstanding voting securities that a fund may own.
The securities laws set higher standards for funds that elect to be diversified. If a fund elects to be diversified, the Investment Company Act requires that, with respect to at least 75 percent of the portfolio, no more than 5 percent may be invested in the securities of any one issuer and no investment may represent more than 10 percent of the outstanding voting securities of any issuer. Diversification is not mandatory, but all mutual funds, closed-end funds, and ETFs must disclose whether or not they are diversified under the Act’s standards.
In practice, most funds that elect to be diversified are much more highly diversified than they need to be to meet these two tests. As of December 2012, for example, the median number of stocks held by U.S. equity funds was 98.17
17This number is the median (the midpoint of a range of numbers that are arranged in order of value) among U.S. actively managed and index equity funds, excluding sector funds.