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The Independent Directors Council (IDC) created this material as an information resource for newer fund directors. This material is designed to help newer directors understand the legal and regulatory framework within which investment company directors operate, and their role and responsibilities within that framework.

The Fund Industry

compassMutual funds and other U.S.-registered investment companies play a significant role in the U.S. economy and world financial markets. These funds held more than $16 trillion in assets for more than 90 million U.S. investors as of December 31, 2013. Funds supply investment capital in securities markets around the world and are among the largest group of investors in the U.S. stock, commercial paper, and municipal securities markets. Firms providing fund services employed 166,177 U.S. workers as of spring 2013.

In 2012 there were 776 financial firms from around the world that competed in the U.S. market as sponsors of investment companies, providing investment management services to fund investors. Banks, insurance companies, securities broker-dealers, and non-U.S. fund advisers may sponsor investment companies in the U.S. marketplace. Approximately 76 percent of U.S. fund sponsors, though, are independent fund advisers, and they manage close to two-thirds of investment company assets.

Types of Funds

In the United States, fund sponsors offer four types of registered investment companies: open-end funds (commonly called mutual funds), closed-end funds, exchange-traded funds (ETFs), and unit investment trusts (UITs).

Mutual Funds

Mutual funds can have actively or passively managed portfolios. For actively managed portfolios, the adviser creates a unique mix of investments to meet a particular investment objective. For passively managed portfolios, the adviser seeks to track the performance of a selected benchmark or index. 

key terms
Forward pricing.The concept describing the price at which mutual fund shareholders buy or redeem fund shares. Shareholders must receive the next computed share price following the fund's receipt of a shareholder transaction order.

One hallmark of mutual funds is that they issue "redeemable securities," meaning that the fund stands ready, every day, to buy back its shares at their current net asset value, or NAV. The NAV is calculated when the markets close by dividing the total market value of the fund's assets, minus its liabilities, by the number of mutual fund shares outstanding. As of December 31, 2013, there were 8,977 mutual funds with total assets more than $15 trillion.

Closed-End Funds

Unlike a mutual fund, a closed-end fund does not issue redeemable shares. Instead, it issues a fixed number of shares that trade intraday on a stock exchange. As a result, the share price of a closed-end fund is determined by the market, unlike that of a mutual fund. This market-determined price may differ from the fund's NAV. Investors in a closed-end fund buy or sell shares through a broker or via a brokerage account, just as they would the shares of any publicly traded company. As of September 30, 2013, there were 604 closed-end funds with total assets of over $277 billion.

Exchange-Traded Funds

ETFs are, practically speaking, hybrid investment companies in that they are structured, in part, like an open-end fund and, in part, like a closed-end fund. They are structured and legally classified as mutual funds or UITs (discussed below), but trade intraday on stock exchanges like closed-end funds.

key terms
Intraday indicative value (IIV). A real-time estimate of an ETF’s intraday value. Third-party providers calculate and disseminate this measure every 15 to 60 seconds during securities markets trading hours.

ETFs only buy and sell fund shares directly to certain third-party "authorized participants" (typically broker-dealers) in large blocks known as creation units, which often are 50,000 shares or more. The third parties who purchase the creation units then sell the shares on an exchange so that, to the ultimate investor, the purchase and sale of ETF shares is much like the purchase and sale of closed-end fund shares. The price at which ETF shares trade is determined by the market. As of December 31, 2013, there were 1,332 ETFs with total assets of $1,675 billion.

Unit Investment Trusts

UITs are also a hybrid, with some characteristics of mutual funds and some of closed-end funds. Like mutual funds, UITs issue redeemable shares. Like closed-end funds, however, UITs typically issue only a specific, fixed number of shares. A UIT does not actively trade its investment portfolio, instead it buys and holds a set of particular investments until a set termination date, at which time the trust is dissolved and proceeds are paid to shareholders. Unlike other investment companies, a UIT is not required to have a board of directors, corporate officers, or an investment adviser. As of December 31, 2012, there were 5,787 UITs with assets of $72 billion.

Legal Framework

The remainder of this material will focus primarily on mutual funds because the vast majority of investment companies, both in terms of number of funds and assets under management, are mutual funds. Even so, many of the concepts are common to all types of registered investment companies.

buildingMutual funds are complex, stringently regulated financial institutions that must comply with a variety of federal laws and regulations. Funds must be registered under the Investment Company Act of 1940 (the 1940 Act) and their shares typically are registered under the Securities Act of 1933. The fund industry's principal regulator is the U.S. Securities and Exchange Commission (SEC).

Mutual funds offer investors many benefits, principally the chance to own liquid, diversified, professionally managed portfolios at a relatively low cost. Mutual fund shareholders are also protected by an array of securities laws that set funds apart from many other types of financial products. The 1940 Act goes far beyond the disclosure and antifraud requirements characteristic of the other federal securities laws and imposes substantive requirements and prohibitions on the structure and day-to-day operations of mutual funds. The core objectives of the 1940 Act are to:

  • require a high degree of independent oversight and accountability;
  • guard against conflicts of interest;
  • protect the physical integrity of the fund's assets;
  • guard against potentially problematic affiliated transactions and prohibit other forms of self-dealing;
  • protect against potentially unfair and unsound capital structures (by, for example, placing constraints on the use of leverage);
  • pursue transparency and accuracy of the liquidity and valuation of fund shares (by, for example, requiring mutual fund NAVs to be calculated and marked-to-market daily); and
  • ensure that investors receive appropriate information about the mutual funds in which they invest and that the information is accurate and not misleading.

In addition, those who sell fund shares to the public are subject to regulation as broker-dealers under the Securities Exchange Act of 1934 (1934 Act). The sales practices of broker-dealers are, in turn, regulated by the Financial Industry Regulatory Authority (FINRA). It is important to note that the offer and sale of mutual fund shares also may be subject to notice filing requirements and antifraud prohibitions under state law. Investment advisers to funds must register with the SEC under the Investment Advisers Act of 1940 (Advisers Act). In addition, investment advisers and subadvisers to funds that invest in derivatives may be required to register with the Commodity Futures Trading Commission (CFTC) as commodity pool operators and commodity trading advisors under the Commodity Exchange Act and become members of the National Futures Association. Finally, the Internal Revenue Code of 1986 grants pass-through tax treatment to mutual funds, which means that mutual funds are not subject to taxation on their income and capital gains at the entity level, so long as they meet certain gross income, asset, and distribution requirements.

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