Investment Companies: Mutual Funds and More
About This Lesson
Investment companies pool money from many investors and put a professional manager in charge of it, and mutual funds are the version almost everyone meets first. The SIE tests the structure (what kinds of funds exist and how they are priced), the costs (loads, share classes, and breakpoints), and the rules that protect fund investors. Most of it is conceptual rather than mathematical, with one formula, the public offering price, worth committing to memory.
What you'll cover
- the three investment-company types and the open-end versus closed-end split
- net asset value, the public offering price, and the A/B/C share classes
- breakpoints, rights of accumulation, letters of intent, and breakpoint-selling violations
- diversification (the 75-5-10 test), fund restrictions, prohibited practices, and taxation
This is the sixth chapter of the products module.
Types of Investment Companies
The Investment Company Act of 1940 defines three types of investment company, and the exam expects both the categories and how they differ.
- Face-amount certificate companies issue a contract promising to pay a fixed sum at a future date. They are largely a historical category and rarely come up today beyond the name.
- Unit investment trusts (UITs) hold a fixed portfolio with no active management and no board of directors. They issue redeemable units and carry a set termination date when the portfolio is liquidated.
- Management companies are the managed funds most investors picture, and they split into two forms.
That last category is where mutual funds live, and the SIE leans hardest on the split between its two forms:
Open-end funds (mutual funds)
- continuously issue and redeem their own shares at net asset value
- are priced once a day after the close, with orders filling at the next calculated NAV (forward pricing)
- may carry a sales load, and must honor redemptions within 7 days
Closed-end funds
- issue a fixed number of shares through an IPO, then stop
- trade on an exchange like a stock at a price set by supply and demand, which can sit at a premium or discount to NAV
| Open-End Fund (Mutual Fund) |
Closed-End Fund | ETF | Unit Investment Trust | |
|---|---|---|---|---|
| Shares issued | Continuous, redeemed/issued daily | Fixed at IPO | Flexible via creation/redemption | Fixed at formation |
| Where traded | Direct with fund company only | Stock exchange (secondary market) | Stock exchange (secondary market) | OTC or direct with sponsor |
| Priced at | NAV (end of day only) | Market price (can differ from NAV) | Market price throughout day | NAV |
| Premium/discount possible? | No, always NAV | Yes, common | Yes, but usually small | No |
| Active management? | Usually yes | Usually yes | Usually passive (index) | No, fixed portfolio |
| Portfolio changes? | Yes, ongoing | Yes, ongoing | Yes, ongoing | No, frozen at creation |
| Redeemable? | Yes, directly from fund at NAV | No, sell on exchange | Retail: sell on exchange. APs: in-kind | Yes, typically at NAV |
| Leverage allowed? | No | Yes | Generally no | No |
| Typical example | Vanguard 500 Index Fund (VFINX) | Adams Diversified Equity Fund (ADX) | SPDR S&P 500 (SPY) | iShares Bond ladder UITs |
Key exam trap: Closed-end funds are the only investment company type that can trade at a significant and persistent premium or discount to NAV. Open-end mutual funds always redeem at NAV, there is no premium or discount. ETFs trade at market price but the arbitrage mechanism keeps them very close to NAV.
NAV, Loads & Share Classes
Mutual funds charge both for the sales effort and for ongoing operations, and the SIE tests how those charges differ across share classes.
- Class A shares carry a front-end load paid at purchase, in exchange for lower ongoing expenses. They are the class that offers breakpoint discounts on large investments.
- Class B shares carry a back-end load, a contingent deferred sales charge (CDSC) paid only if you sell within a set window, with the charge declining the longer you hold. They run higher 12b-1 fees.
- Class C shares carry a level load: little or no front-end charge, a small CDSC if you sell within about a year, and higher ongoing 12b-1 fees.
12b-1 fees are annual marketing and distribution fees charged against the fund itself, capped at 0.75% for distribution plus a 0.25% service fee, and they are folded into the fund's expense ratio.
Front-end load (Class A shares): Charged at purchase. POP = NAV ÷ (1 − sales charge %). Example: NAV $9.50, 5% load → POP = $9.50 ÷ 0.95 = $10.00.
Back-end load / CDSC (Class B shares): Charged when selling, typically declining over time (e.g., 5% in year 1, 4% in year 2, and stepping down to 0% after year 6).
Class C shares: Level load with higher ongoing 12b-1/service fees, plus often a small short-term CDSC if sold within about a year. Better for shorter holding periods than Class A, but not for long-term buy-and-hold.
No-load funds: No sales charge. Purchased directly from the fund. Still have an expense ratio (management fee). The expense ratio is NOT a load.
An open-end mutual fund has an NAV of $18.00 and charges a 4% front-end load. What is the public offering price (POP)?
Breakpoints & Sales-Charge Rules
Class A front-end loads come down as the investment grows, and the SIE tests the three ways an investor reaches those discounts.
- Breakpoints are the volume discounts themselves, lower sales-charge percentages that kick in at set investment thresholds.
- Rights of accumulation (ROA) let an investor count the current value of existing holdings toward the next breakpoint.
- A letter of intent (LOI) is a commitment to invest enough to reach a breakpoint within 13 months, earning the discount up front; it can also be backdated up to 90 days to capture a recent purchase.
Which share class of mutual fund typically offers breakpoint discounts on sales charges?
Diversification, Restrictions & Taxation
The Investment Company Act also sets the bar a fund must clear to call itself diversified, and the test, known as 75-5-10, is worth memorizing.
For at least 75% of its total assets, a diversified fund may put no more than 5% in any single issuer and may own no more than 10% of any single issuer's outstanding voting securities. The other 25% of the portfolio is free of those limits.
A fund that does not meet 75-5-10 is non-diversified. It can concentrate in fewer holdings or a single sector, which raises both the risk and the potential reward; sector funds are the usual example.
The Investment Company Act puts several hard limits on how a mutual fund operates:
- it cannot buy securities on margin or sell short
- it must price its shares at NAV at least once each business day (forward pricing) and redeem within 7 calendar days of a proper request
- it must hold an initial net worth of at least $100,000 before offering shares to the public
- its board must be at least 40% independent (non-interested) directors
- changing the fund's investment objective requires shareholder approval
A separate set of prohibited sales practices shows up constantly on the exam:
- Breakpoint selling: steering a purchase just below a breakpoint to earn a higher commission, a FINRA violation.
- Late trading: entering an order after the 4:00 PM ET close but receiving that day's NAV, which is illegal.
- Market timing: rapid in-and-out trading to exploit stale pricing, which most funds prohibit.
- Switching: moving a customer between fund families to generate fresh sales charges without a real reason.
How a fund's payouts are taxed is a reliable exam topic:
- Dividend distributions come from the fund's net investment income (the interest and dividends it collects) and are taxed as ordinary income or, if they qualify, at the lower qualified-dividend rate.
- Capital gains distributions are paid when the fund sells holdings at a net gain, and are taxed as long-term gains if the fund held those positions more than a year, regardless of how long the shareholder has owned the fund.
- Return of capital is not income at all; it reduces the investor's cost basis and is not taxed when received.
- Reinvested distributions are still taxable in the year they are paid, even when automatically plowed back into more shares, a favorite exam trap.
Under the 75-5-10 diversification test, a diversified mutual fund may invest no more than what percentage of its total assets in any single issuer (for the required 75% of assets)?
Which of the following is a prohibited practice when selling mutual funds?
Chapter Essentials
The 1940 Act defines three investment companies, face-amount certificate companies, unit investment trusts, and management companies, and management companies split into open-end mutual funds (continuously issued and redeemed at NAV, forward priced) and closed-end funds (a fixed share count, trading on an exchange at a premium or discount to NAV). NAV is assets minus liabilities over shares outstanding.
On costs, Class A shares take a front-end load and earn breakpoint discounts, Class B a declining back-end CDSC, and Class C a level load. The public offering price is NAV ÷ (1 − sales charge). A diversified fund clears the 75-5-10 test, and the classic violations, breakpoint selling, late trading, and market timing, recur on the exam. Reinvested distributions are still taxable.
The reliable fund gotchas:
• Open-end redeems; closed-end trades. Open-end funds issue and redeem their own shares at NAV; closed-end funds have a fixed share count and trade on an exchange at a market price that can run at a premium or discount to NAV.
• POP divides, it does not multiply. Public offering price = NAV ÷ (1 − sales charge). An $18 NAV with a 4% load is $18 ÷ 0.96 = $18.75, not $18 × 1.04.
• Class A gets the breakpoints. Volume discounts on the front-end load belong to Class A shares; an LOI (13 months) or rights of accumulation can help an investor reach one.
• Breakpoint selling is the trap answer. Steering a purchase just below a breakpoint to earn a bigger commission is a FINRA violation; recommending the discount is exactly what the rep is supposed to do.
• 75-5-10 caps single issuers. For 75% of assets, a diversified fund holds no more than 5% in one issuer and no more than 10% of an issuer's voting shares.
• Reinvested still means taxable. Automatically reinvested dividends and capital gains are taxed in the year distributed, even though no cash reaches the investor.
Mutual funds, UITs, closed-end funds, the 75-5-10 rule and more, in one overview.
Test yourself with exam-style questions on this topic.