5.1 Investment Company Basics

Investment Companies on the Series 7

An investment company pools money from many investors and invests it in a portfolio of securities on their behalf. The Series 7 exam (125 scored questions, 225 minutes, 72% passing, administered by Prometric for FINRA) treats investment companies as high-frequency material, so memorize the structural distinctions cold. The governing statute is the Investment Company Act of 1940, which requires registration with the SEC, prohibits self-dealing, and mandates disclosure through a prospectus.

The Three Statutory Types

The Act of 1940 recognizes exactly three categories. The exam loves to ask which bucket a product falls into.

Face-Amount Certificate Companies

These issue a debt-like certificate promising a stated face amount on a future date in exchange for periodic or lump-sum payments. They are essentially obsolete; the exam only expects you to recognize the term as one of the three types.

Unit Investment Trusts (UITs)

A UIT buys a fixed, unmanaged portfolio and sells redeemable units of beneficial interest. Key facts the exam tests:

• No board of directors and no investment adviser — the portfolio is fixed at inception, so there is nothing to manage.
• A specified termination date; the trust dissolves and distributes proceeds at maturity.
• Units are redeemable with the trust, though a secondary market may also exist.
• A UIT supervised by a sponsor underlies many variable annuity and ETF structures, which is why the term recurs throughout the exam.

Management Companies

A management company actively manages (or indexes) its portfolio and divides into two subtypes:

• Open-end (mutual fund): continuously issues new, redeemable shares; never trades on an exchange; priced at NAV.
• Closed-end: raises capital once through an IPO of a fixed share count; shares then trade on an exchange at a market price set by supply and demand, independent of NAV.

Redeemable vs. Negotiable Securities

This distinction drives several answers:

• A redeemable security (open-end fund share, UIT unit) is sold back to the issuer at NAV; there is no public trading market.
• A negotiable security (closed-end fund share, ETF share) trades between investors on an exchange.

Board and Governance Rules

The Act of 1940 imposes governance requirements designed to protect shareholders from insiders, called interested persons (affiliates such as the adviser or its officers).

• At least 40% of the board must be non-interested (independent) directors.
• Certain actions — selecting the independent auditor or approving the underwriting/advisory contract — require approval by a majority of the independent directors.
• A board that is more than 60% interested is prohibited.

Prospectus and Disclosure

Before or at the time of sale, the customer must receive a prospectus. Funds may use a concise summary prospectus delivered with online access to the full statutory prospectus. The Statement of Additional Information (SAI) holds extra detail and must be sent free on request. The prospectus discloses objectives, strategies, fees and expenses, risks, past performance, and management. A common trap: the prospectus may not make performance guarantees or promise specific returns.

Open-End vs. Closed-End at a Glance

Because so many exam questions hinge on the open-end/closed-end split, internalize the chain of consequences. An open-end fund issues an unlimited, continuously offered number of redeemable shares. Every purchase creates new shares, and every redemption retires shares back to the fund, so the share count constantly changes. Pricing is anchored to NAV and uses forward pricing, meaning the investor never knows the exact execution price at the moment of the order. Open-end shares never trade on an exchange and carry no market-set bid-ask spread — the fund is always both buyer and seller.

A closed-end fund raises a fixed pool of capital one time in an IPO; after that, the share count is essentially frozen. Shares are then negotiable and change hands between investors on an exchange at a price set purely by supply and demand. The fund neither issues new shares routinely nor redeems them, so the market price can drift to a premium above NAV or a discount below it for extended periods. Because closed-end shares trade like stock, an investor pays a brokerage commission rather than a sales load, can place limit and stop orders, and can sell short.

How a Fund Is Organized

A management company is typically a corporation or business trust with a board of directors that hires outside service providers under contract: the investment adviser manages the portfolio for an advisory fee, the custodian (usually a bank) safeguards the cash and securities, the transfer agent issues and redeems shares and maintains shareholder records, and the underwriter (sponsor/distributor) markets the shares. Advisory and underwriting contracts must be approved initially by shareholders and renewed annually by the board, including a majority of the independent directors.

Knowing these roles helps you answer questions about who does what when a prospectus describes a fund's operations.

Exam Trap: A UIT has no board and no adviser because its portfolio is fixed. If a question gives a product a 'portfolio manager' or 'board of directors,' it is a management company, not a UIT.