Types of Pooled Investments

Open-end and closed-end funds — the basic split

Two of the three categories of management companies under the Investment Company Act of 1940 are open-end funds (usually just called mutual funds) and closed-end funds. The next sections take each apart, but at a high level:

• Open-end funds (mutual funds) — continuously issue and redeem shares at net asset value (NAV). Priced once daily after market close ("forward pricing"). Must register with the SEC under the 1940 Act. Investors buy from and sell back to the fund company.
• Closed-end funds — issue a fixed number of shares through an IPO. Trade on exchanges throughout the day like stocks. Can trade at a premium or discount to NAV. Do not redeem shares — investors who want to exit must sell on the secondary market.

The Investment Company Act of 1940 framework

The Investment Company Act of 1940 defines an “investment company” as a firm whose main business is investing, reinvesting, or trading in securities for its shareholders. The Act sets up three categories of registered investment company:

Two more points the Series 66 expects you to know:

• REITs are NOT investment companies under the 1940 Act. They operate under separate Internal Revenue Code provisions and may be exempt from 1940 Act registration. The distinction matters for fee, governance, and disclosure rules.
• Private funds (hedge funds, PE, VC) avoid 1940 Act registration via the 3(c)(1) exemption (up to 100 investors, all accredited) or 3(c)(7) exemption (qualified purchasers only, no investor cap). Without an exemption, all three would be subject to the same retail-investor protections that constrain mutual funds.

Open-end mutual funds — the dominant pooled vehicle

An open-end mutual fund continuously issues new shares to investors coming in and redeems shares from those going out — both at the fund's net asset value (NAV). It's “open” in the sense that the share count floats rather than being fixed.

Key mechanics:

• Continuous issuance and redemption. The fund stands ready to issue new shares to anyone who wants to invest and to redeem shares from anyone who wants to sell, at NAV. The fund sponsor (not an exchange) is the counterparty.
• NAV is calculated once per trading day, typically as of 4:00 PM Eastern when major U.S. markets close. NAV per share = (total fund assets − total fund liabilities) ÷ shares outstanding.
• Forward pricing rule. Investors who place buy or sell orders during the day transact at the next calculated NAV, not the previous day's NAV. The investor doesn't know the exact transaction price until after the order is placed. This is a SEC rule designed to prevent late-trading abuses.
• Always trade at NAV. Open-end funds never trade at a premium or discount — the fund sponsor's continuous-redemption mechanism prevents any divergence between price and NAV.

Mutual funds dominate retail investing in the U.S. — nearly half of all households hold them in some form, usually inside 401(k)s and IRAs. Professional management, diversification, daily liquidity, and low minimums have kept them the default retail pooled vehicle for decades.

Diversified vs. non-diversified — the 75-5-10 rule

The 1940 Act splits management companies into two classes by how concentrated their portfolios are. A fund can call itself “diversified” only if it clears the 75-5-10 test:

What this means in practice:

• A diversified fund spreads risk by limiting concentration in any single name. Most index funds and broad-market mutual funds qualify as diversified.
• A non-diversified fund can hold larger positions in fewer names. Sector funds, concentrated active strategies, and many ETFs declare themselves non-diversified even when their actual portfolios appear well-spread.

The Series 66 tests the 75-5-10 thresholds directly — and the subtler point that non-diversified doesn't automatically mean “risky.” It just means the fund keeps the freedom to concentrate. A fund can be non-diversified by charter while actually holding 200 names; the label is about the constraint, not the current portfolio.

Active vs. passive management

Mutual funds (and ETFs, covered in §3) come in two basic management styles:

The evidence for indexing has only gotten stronger: over multi-decade windows most actively managed funds trail their benchmarks net of fees, and the shortfall is roughly the size of the expense-ratio gap. That lines up with the Efficient Market Hypothesis (§5 of the equity-valuation chapter): if markets are even semi-strong-form efficient, beating them after fees on public information alone is mathematically unlikely on average.

Active vs. passive is the single biggest cost decision a retail investor makes. The Series 66 doesn't pick a side, but it expects suitability analysis that accounts for the after-fee return gap.

Closed-end funds — fixed share count, exchange-traded

A closed-end fund (CEF) issues a fixed number of shares through an IPO and then lets them trade on an exchange. Unlike open-end funds, CEFs don't continuously issue or redeem shares — an investor who wants out sells to another investor on the secondary market, with the fund standing aside.

The fixed share count creates the defining feature of CEFs — their market price can diverge from NAV. Three reasons:

• Trading at a premium — market price above NAV. Reflects strong demand for the fund's strategy, manager reputation, or scarce access (e.g., emerging-market closed-end funds when the underlying market is restricted).
• Trading at a discount — market price below NAV. Common, often 5-15% below NAV. Reflects weak demand, high fees, illiquid underlying holdings, or general distrust.
• No arbitrage mechanism. Unlike ETFs (covered next), there's no authorized-participant creation/redemption process to keep CEF price near NAV. Discounts can persist for years.

Most CEFs lever up to boost distributions, borrowing through preferred stock or debt issuance up to 50% of net assets. Leverage cuts both ways, and the borrowing costs eat into distributions when rates are high. The Series 66 wants you to recognize the CEF discount/premium dynamic — and to name the missing creation/redemption process as the structural reason for it.

Unit Investment Trusts (UITs)

A Unit Investment Trust holds a fixed, unmanaged portfolio of securities for a set term, then dissolves and hands the proceeds back to unit holders. A UIT is conceptually closer to a bond-with-an-end-date than to a traditional mutual fund.

Defining features:

• Fixed portfolio. The securities are selected at inception and held until the trust terminates. No active manager, no portfolio turnover, no rebalancing.
• Stated termination date. A UIT might have a 5-, 10-, or 30-year life. At termination, the underlying securities are sold and proceeds returned to unit holders.
• Redeemable at NAV. Unit holders can sell units back to the trust at NAV at any time before termination. Some UITs also trade on secondary markets.
• No board of directors, no investment adviser. The trust structure is essentially a buy-and-hold vehicle for a predetermined set of securities.

UITs were once heavily used for bond portfolios (think a 10-year UIT holding a bond ladder), but their slice of the investment-company market has shrunk a lot as ETFs and target-date funds took over the same jobs. Today they show up mostly as defined-portfolio products from a handful of sponsors (Invesco, for example), often holding thematic or dividend-focused equity baskets.

ETFs — 1940 Act structure with exchange trading

An Exchange-Traded Fund (ETF) bolts the legal structure of an open-end mutual fund (registered under the 1940 Act) onto the trading mechanics of a closed-end fund (exchange-listed, priced throughout the day). The hybrid captures most of the benefits of both:

• Intraday trading. Buy and sell during market hours at then-prevailing prices. Unlike open-end funds, no forward-pricing lag.
• Marginable and shortable. Treated as stocks for trading purposes — can be bought on margin and sold short.
• Mostly passively managed. The original ETF model was index-tracking, and most large ETFs remain index funds. Active ETFs have grown rapidly post-2019 but are still a minority of total ETF assets.
• Tax-efficient. The in-kind creation/redemption mechanism (covered next) limits the realized capital gains that flow through to shareholders — a meaningful advantage over comparable mutual funds for taxable accounts.

ETFs come in many flavors:

• Index ETFs tracking broad-market indexes (SPY for S&P 500, VTI for total U.S. stock market, AGG for aggregate bond).
• Sector and thematic ETFs tracking industry or thematic baskets (technology, healthcare, clean energy, robotics).
• Bond ETFs tracking aggregate, Treasury, corporate, or municipal bond indexes.
• Leveraged and inverse ETFs using derivatives to deliver 2x or 3x the daily return (or its inverse). Generally unsuitable for buy-and-hold investors due to compounding decay.
• Smart-beta / factor ETFs using rules-based methodology to weight by factors like value, momentum, quality, or low volatility.

Authorized participants and the creation/redemption mechanism

The most important structural feature of an ETF is the creation/redemption process run by Authorized Participants (APs). It's what holds the ETF's market price near NAV even though retail investors have no direct redemption right.

How it works:

• APs are large institutional firms (usually major investment banks like Goldman Sachs or large market makers) authorized by the ETF sponsor to create and redeem ETF shares in large blocks called "creation units" (typically 50,000 to 100,000 shares).
• Creation: The AP delivers a basket of the underlying securities (matching the ETF's holdings) to the ETF sponsor and receives a creation unit of ETF shares in exchange. New ETF shares enter the market.
• Redemption: The AP delivers a creation unit of ETF shares to the ETF sponsor and receives a basket of underlying securities in exchange. ETF shares are removed from the market.

The arbitrage mechanism that keeps price near NAV:

• If the ETF trades at a premium to NAV, APs create new shares: they buy the underlying basket (at NAV cost), exchange it for ETF shares (worth premium), and sell those ETF shares in the market at the premium. The selling pressure drives the ETF price down toward NAV. AP captures the premium as arbitrage profit.
• If the ETF trades at a discount to NAV, APs redeem shares: they buy the ETF in the market at the discount, deliver it to the sponsor, receive the underlying basket (worth NAV), and sell the basket at full NAV value. The buying pressure drives the ETF price up toward NAV. Again, AP profits from the gap.

Two nice side effects of the in-kind creation/redemption: it keeps the ETF's realized capital gains low (the AP gets securities, not cash, so no sale happens), and it applies natural pressure toward NAV without the sponsor having to prop up the price itself.

Open-end · closed-end · ETF · UIT — side by side

REIT structure and three subtypes

A Real Estate Investment Trust (REIT) is a corporation or trust that owns or finances income-producing real estate. REITs are NOT registered under the Investment Company Act of 1940 — they run under separate Internal Revenue Code provisions (Subchapter M). To earn the favorable tax treatment, a REIT has to meet several conditions, the most important being:

• Distribute at least 90% of taxable income to shareholders annually. This is the defining REIT requirement and the source of their high-dividend reputation.
• Derive at least 75% of gross income from real estate sources (rents, mortgage interest, property sales).
• Hold at least 75% of assets in real estate, cash, or government securities.
• No more than 50% of shares can be held by 5 or fewer individuals ("5-or-fewer rule") — prevents the structure from being used as a personal investment vehicle.

REITs come in three subtypes based on what they hold:

Tax treatment of REIT distributions:

• Ordinary REIT dividends are taxed at the investor's ordinary income rates — NOT qualified dividend rates — because the REIT itself doesn't pay corporate tax (passthrough treatment).
• Section 199A deduction (Tax Cuts and Jobs Act, 2017) allows individual investors to deduct 20% of qualified REIT dividends, effectively lowering the top federal rate on REIT income.
• Return-of-capital distributions are not currently taxable; they reduce the investor's cost basis in the REIT.

Public-traded, non-traded, and private REITs

REITs also differ in how tradable they are and what disclosure they owe:

The non-traded REIT is the Series 66's favorite trap. The exam will hand you a retiree, a near-term liquidity need, or a limited-net-worth investor and ask whether a non-traded REIT is suitable. The answer is almost always NO, because:

• Limited liquidity — no active secondary market; redemption windows are restricted, often quarterly with low caps.
• High upfront commissions — typically 10-15% of investment, which immediately impairs the investor's principal.
• Opaque valuations — the sponsor sets the NAV, not the market. Investors may not know the real value until forced to sell at a discount.
• Long time horizon required — only suitable for investors with no near-term liquidity needs and the patience to wait years for the REIT to dispose of properties.

Private funds — the three flavors at a glance

Private funds are exempt from SEC registration (under the 3(c)(1) or 3(c)(7) exemptions to the Investment Company Act) and sold to accredited and qualified investors. Three families dominate the landscape:

• Hedge funds. Use leverage, short selling, derivatives, and other flexible strategies. Often charge "2 and 20" fees. Returns can come from any market environment depending on the strategy.
• Private equity. Invest in non-public companies through buyouts, growth equity, and distressed strategies. Long lock-up periods (5-10+ years). The dominant alternative-asset category by AUM.
• Venture capital. Invest in early-stage startups. Very high risk with potential for very high returns; success driven by a small number of "outlier" wins offsetting many losses.

The next subsections get into the strategy specifics, fee structures, and liquidity restrictions for each. The suitability theme stays constant: private funds demand long time horizons, real net worth, and a tolerance for opacity and illiquidity.

Hedge fund strategies

Hedge funds are private investment funds exempt from 1940 Act registration (under 3(c)(1) or 3(c)(7)) that run a wide range of strategies. Despite the name, modern hedge funds rarely just “hedge” — they chase absolute returns with broad latitude on instruments, leverage, and concentration.

Major strategy categories:

• Long/short equity. Buy stocks expected to rise; short stocks expected to fall. Profit from the relative outperformance regardless of overall market direction. The historical archetype of the hedge fund.
• Market neutral. Equal long and short exposure designed to eliminate market beta and capture only the manager's stock-selection skill (alpha). In theory, returns independent of market direction.
• Macro / global macro. Take directional bets on currencies, commodities, interest rates, and equity indexes based on macroeconomic views. Examples: betting on a currency devaluation, or on rate cuts in a particular country.
• Event-driven / merger arbitrage. Trade around corporate events — M&A deals, bankruptcies, spin-offs. Merger arb specifically buys the target's stock after a deal is announced, capturing the spread between current price and deal price.
• Distressed debt. Buy debt of companies in or near bankruptcy at deep discounts, profit from restructuring or liquidation outcomes.
• Quantitative / systematic. Rules-based strategies driven by statistical models. Examples: statistical arbitrage, trend-following, factor strategies.

Hedge funds typically charge “2 and 20” — a 2% annual management fee plus 20% of profits above a hurdle rate — usually with a “high-water mark”: the manager earns the 20% only on net new profits, not on clawing back prior losses.

Private equity and venture capital

Both PE and VC use fee structures much like hedge funds (typically 2 and 20), with one important wrinkle: carried interest — because the investments are held for years, the 20% profit share is taxed at long-term capital gains rates rather than ordinary income. That treatment is politically contested but has survived multiple reform attempts.

Lock-ups, gates, and investor requirements

Private funds clamp down hard on liquidity — investors can't redeem on demand the way mutual fund holders can. The exact restrictions vary by vehicle:

• Hedge fund lock-ups. Typically 1-2 years from initial investment, during which no redemption is allowed. After lock-up expiration, redemptions are usually limited to quarterly windows with 30-90 days' notice.
• Gates. When too many investors try to redeem at once, the manager can "gate" the fund — limiting total redemptions to a percentage of assets per quarter. Common in market stress periods (2008, March 2020).
• Side pockets. Illiquid positions can be carved out into a separate "side pocket" that doesn't participate in redemptions until those specific investments are realized.
• PE and VC capital commitments. Investors don't fund the full amount at signing — they commit a maximum, and the manager "calls" capital as investments are made. Calls happen over a 4-6 year investment period, with capital returned over subsequent years as investments are exited.

Investor requirements for private funds come from SEC rules and the fund's own offering documents:

• 3(c)(1) funds — limited to 100 investors, all of whom must be accredited.
• 3(c)(7) funds — no investor cap, but ALL investors must be qualified purchasers ($5 million+ in investments for individuals; $25 million+ for institutional QPs).
• Practical minimums — most hedge funds require $1 million minimum investment; some "platform" funds offer access at $250,000 or lower through fund-of-funds structures.

Hedge funds · PE · VC — side by side