This appendix provides an overview of the core principles of mutual funds and other registered investment companies that provide important protections for shareholders.

Oversight and Accountability

Limits on Leverage

Custody

Prohibitions on Transactions with Affiliates

Diversification

Embedded in the structure and regulation¹ of mutual funds and other registered investment companies² are several core principles that provide important protections for shareholders.

Transparency

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.³ 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 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 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 Securities and Exchange Commission 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 have not become stale.⁴ These funds also amend registration statements throughout the year as necessary to reflect material changes to their disclosure.

Fund disclosure continues to evolve to better serve investors’ needs. For example, based on a variety of investor outreach efforts, in 2009 the SEC adopted a rule allowing mutual funds and ETFs to provide investors with a “summary prospectus” containing key information about the fund, while making more information available on the Internet and in paper upon request.

In addition to registration statement disclosure, funds provide shareholders with several other disclosure documents. Shareholders receive audited annual and unaudited semi-annual reports within 60 days after the end and the mid-point of the fund’s fiscal year. These reports contain updated financial statements, a list of the fund’s portfolio securities,⁵ management’s discussion of financial performance, and other information current as of the date of the report.

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 semi-annual 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 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 critically important as a 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 board 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.⁶

This daily valuation process results in a net asset value, or 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.⁷ 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.

The Investment Company Act of 1940 requires mutual funds to process transactions based upon “forward pricing,” meaning that shareholders receive the next computed share price (NAV) following the fund’s receipt of their transaction order. So, for a fund that prices its shares at 4:00 p.m.,⁸ orders received prior to 4:00 p.m. receive the price determined that same day at 4:00 p.m. Orders received after 4:00 p.m. receive the price 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.

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 exceptions⁹) 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.¹⁰ 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.

Oversight and Accountability

All funds are subject to a strong system of oversight from both internal and external sources. Internal oversight mechanisms include boards of directors or trustees, which include independent directors, and written compliance programs overseen by chief compliance officers, 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.

Fund Boards

Mutual funds, closed-end funds, and most ETFs are organized as corporations, with boards of directors, or business trusts, with boards of trustees. Unlike boards of operating companies, these fund boards must maintain a particular level of independence. The Investment Company Act 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 or trustee 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 or trustees. As of year-end 2008, independent directors comprised at least three-quarters of boards in almost 90 percent of fund complexes.¹¹

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.

Compliance Programs

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 chief compliance officers (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.

Regulatory Oversight

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).

Auditors

Funds’ 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.

Sarbanes-Oxley

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 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. Generally speaking, a senior security is any debt that takes priority over the fund’s shares, such as a loan or preferred stock. These limitations greatly minimize the possibility that a fund’s liabilities will exceed the value of its assets.

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.¹² A fund generally can cover an obligation by owning the instrument underlying the leveraged transaction. 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 can also cover by segregating, on its custodian’s books, liquid securities equal in value to the fund’s potential exposure from the leveraged transaction. The assets set aside to cover the leveraged security transactions 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.

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.

Custody

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. Foreign securities are required to be held in the custody of a foreign 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.¹⁵ Shareholders 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 again possible instances of employee larceny and embezzlement.

Prohibitions on Transactions with Affiliates

The Investment Company Act 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 1940 in response to instances of over-reaching 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; and
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.

Diversification

Both tax law and the Investment Company Act provide diversification standards for funds. Under the tax laws, all mutual funds, closed-end funds, and ETFs, as well as most UITs, qualify as “regulated investment companies” (RICs) and, as such, must meet a tax diversification test every quarter.¹⁷ 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 they are diversified under the Act’s standards or not.

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 2009, for example, the median number of stocks held by U.S. equity funds was 93.¹⁸

¹Funds operate pursuant to a comprehensive regulatory scheme that has worked well for nearly 70 years. They are regulated under all four of the major federal securities laws: the Securities Act of 1933; the Securities Exchange Act of 1934; the Investment Advisers Act of 1940; and, most importantly, the Investment Company Act of 1940.

²Fund sponsors offer four types of registered investment companies in the U.S.—open-end investment companies (commonly called “mutual funds”), closed-end investment companies, exchange traded funds (ETFs), and unit investment trusts (UITs). As of December 31, 2009, assets in these funds amounted to more than $12 trillion dollars. This appendix focuses primarily on mutual funds, although many of the concepts are common to all types of registered investment companies. Hedge funds and other private investment vehicles are not registered investment companies and are not discussed in this appendix.

³Closed-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.

⁴Section 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. As a result, mutual funds and ETFs must amend their registration statements within four months after the end of their fiscal year.

⁵A 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.

⁶ICI has published several papers on the mutual fund valuation process. For more information, see ICI’s two white papers entitled 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).

⁷The 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.”

⁸Funds 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.

⁹An example of such an exception would be an emergency that affects markets or funds, such as the assassination of President Kennedy in 1963, the blackouts that affected lower Manhattan in 1990, or earthquakes and other natural disasters. The SEC must declare an emergency to exist to trigger an exception.

¹⁰Effective May 28, 2010, rule amendments will hold money market funds to a stricter standard, limiting illiquid investments to 5 percent of the portfolio. See SEC Release No. IC–29132, 75 Fed. Reg. 10060 (March 4, 2010).

¹¹See Investment Company Institute and Independent Directors Council, Overview of Fund Governance Practices 1994–2008, available at www.ici.org/pdf/pub_09_fund_governance.pdf.

¹²See Securities Trading Practices of Registered Investment Companies, SEC Release No. IC-10666 (April 18, 1979).

¹³Temporary loans cannot exceed 5 percent of the fund’s total net assets and must be repaid within 60 days.

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.

¹⁵“Ponzi” schemes and other frauds involving the misappropriation of assets in unregistered pools or private accounts comprise a significant portion of all SEC enforcement cases. According to the SEC’s Fiscal Year 2009 Performance and Accountability Report, these cases accounted for more than 20 percent of all SEC enforcement actions in fiscal year 2009. The SEC strengthened the custody rules for investment advisers outside of the registered investment company arena in 2009. See Custody of Funds or Securities of Clients by Investment Advisers, SEC Release No. IA-2968 (Dec. 30, 2009), available at http://www.sec.gov/rules/final/2009/ia-2876.pdf. (As noted above, advisers to registered funds are subject to the custody rules in the Investment Company Act.)

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 http://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.

¹⁷Under this test, at least half of the fund’s assets generally must be invested in one or more of the following: cash, government securities, shares of other RICs, or securities with a per-issuer value of no more than 5 percent of the fund’s total net assets. With respect to the other half, no more than 25 percent of the total fund may be invested with one issuer.

¹⁸This number is the median (the midpoint of a range of numbers that are arranged in order of value) among actively managed and index funds, excluding sector funds, primarily invested in equities.

Copyright 2010 Investment Company Institute