'40 Act Funds: An Overview

The Investment Company Act of 1940, often just called the “’40 Act,” is one of the legislative cornerstones of the American financial system. Alongside the Securities Exchange Act of 1934 and the Investment Advisers Act of 1940, the ’40 Act regulates the establishment, operations, and reporting requirements for U.S.-registered investment funds.

The funds registered under the ’40 Act fall into four broad categories: open-end mutual funds, exchange-traded funds (ETFs), closed-end funds (CEFs), and unit investment trusts (UITs).

The SEC defines an investment company as "an issuer that is engaged or proposes to engage in the business of investing, reinvesting, owning, holding, or trading in securities, and owns or proposes to acquire 'investment securities' having a value exceeding 40% of the value of its total assets (exclusive of government securities and cash items) on an unconsolidated basis."

Section 3 of the ’40 Act grants certain registration exemptions to private funds and those that limit their shareholders to accredited investors only. Therefore, although private funds like hedge funds and private debt funds fall under the umbrella of “investment companies,” most of the provisions of the ’40 Act aren’t relevant to their operations.

Below, we cover the basics of each category of registered ’40 Act fund.

OPEN-END MUTUAL FUNDS

Open-end mutual funds, the largest fund category, operate in a model that will be familiar to many investors. Though other fund types can technically be "mutual funds," the term is almost always used to refer to a specific, straightforward, and tremendously popular type of investment vehicle. Mutual funds' defining characteristics are:

· Mutual funds offer daily sale and redemption of shares, which can be bought via a broker or directly from the fund.

· Mutual fund shares are priced daily at net asset value (NAV).

· Mutual funds can be publicly listed and open to all investors or privately offered and only available to accredited or institutional investors.

· Mutual funds are actively managed, but they tend to charge lower fees than closed-end funds.

· Mutual funds typically hold highly liquid securities, with a 15% limit placed on the proportion of illiquid assets they can hold.

EXCHANGE-TRADED FUNDS (ETFs)

ETFs were established by the SEC in 1993, and they’ve grown significantly in popularity since then. Although ETFs can technically operate either as open-end mutual funds or UITs that trade shares on an exchange, their essential characteristics put them in an effective category of their own. Those include:

· ETF shares are bought and sold on an exchange, which is facilitated by an intermediate party acting as an interface between the fund and the traders.

· All ETFs are open to the public, and most of their share transactions happen trader-to-trader without a change in the fund’s underlying holdings.

· Most ETFs are passively managed and track a specific sector or index. Therefore, they tend to have the lowest management fees of all managed ’40 Act funds.

· ETF shares are sold at or very close to NAV, and their value is continuously stabilized by calculated buying and selling by the facilitator of the exchange.

· Like mutual funds, ETFs typically hold highly liquid securities and are subject to the same 15% illiquidity threshold.

TRADITIONAL CLOSED-END FUNDS (CEFs)

Under the definitions provided by the ’40 Act, several different distinct fund types are classified as “closed-end funds.” However, when the term is invoked, it usually refers to the traditional closed-end fund structure. These funds, often called CEFs, are one of the oldest types of investment fund. Their defining characteristics are:

· CEFs offer their shares once during an initial public offering, after which all shares must be bought and sold on a secondary market at market price. This price often deviates significantly from the fund’s NAV.

· CEFs can be either publicly listed and available to all investors or privately offered and available only to accredited investors.

· CEFs are actively managed, and they often have high management fees.

· CEFs have no limit on the proportion of illiquid assets they can hold, and they’re often used to gain exposure to alternative securities not available through open-end mutual funds or ETFs.

OTHER TYPES OF CLOSED-END FUNDS

As noted above, the term “closed-end fund” is highly ambiguous. There are several varieties of ’40 Act fund that are technically closed-end but which offer their shares continuously, initiate periodic portfolio turnover, and provide investors with the opportunity to redeem shares for cash.

· Interval funds continuously offer shares directly from the fund, will redeem shares on regular intervals throughout the year, and are typically used to gain exposure to illiquid, alternative assets. Their shares are bought and sold at NAV, which is calculated daily.

· Tender offer funds are very similar to interval funds, save for the fact that they have more flexibility in when they offer to buy back shares and fewer options for offering new share classes.

· Business development companies can either sell their shares on a secondary market like a CEF or offer them continuously and provide periodic redemption like an interval fund. These funds are used to gain exposure to high-yield debt from small, private companies.

Of these three categories, interval funds represent the largest share of registered closed-end funds. As of 2020, they represent about 18% of CEF assets under management.

Data Source: Investment Companies Institute, 2021 & IntervalFunds.org

UNIT INVESTMENT TRUSTS

UITs, which have fallen out of favor in recent years, offer investors a product that combines characteristics from all of the above-listed fund types. For instance:

· Like a CEF, a UIT offers its shares only once, and it uses the proceeds from that initial public offering to buy a collection of usually fixed-income securities. The fund doesn’t create any more shares throughout its existence.

· Like some CEFs, UITs have a fixed operational lifespan after which its holdings will be liquidated and distributed to its shareholders.

· Like an open-end fund, a UIT will redeem investors’ shares for cash, usually once a day at NAV.

· Unlike the other fund types, UITs don’t have a board of directors, officers, or an investment advisor.

· UITs usually don’t change their portfolios, instead purchasing a pool of securities at the beginning of the fund’s operations and providing dividends to investors via those securities’ fixed-income yields.

BY THE NUMBERS

Of today’s ’40 Act funds, open-end mutual funds dominate both in number of registered funds and total assets. According to the Investment Companies Institute, of the 16,127 registered funds at the end of 2020, 9,027 of those were open-end mutual funds – followed by UITs (4,310), ETFs (2,296), and CEFs (494).

Data Source: Investment Companies Institute, 2021

UITs and mutual funds have been available to investors for longer than ETFs, and in recent years the number of UITs has been trending downward while the quantity of available ETFs has grown considerably.

Data Source: Investment Companies Institute, 2021

Mutual funds hold the lion’s share of total assets under management, controlling $23.9 trillion of the $29.7 trillion managed by U.S.-registered ’40 Act funds. This is followed by $5.5 trillion in ETFs, $279 billion in CEFs, and $78 billion in UITs.

Data Source: Investment Companies Institute, 2021

In the same theme: total assets for both mutual funds and ETFs have been growing steadily in recent years, while the money managed by CEFs and UITs has been comparatively small and flat.

Data Source: Investment Companies Institute, 2021

Though it's difficult to create accurate predictions from past trends, the growing popularity of both mutual funds and ETFs indicate a widening of the existing volume gaps among '40 Act Funds. As more retail investors enter a space traditionally reserved for financial professionals, trends toward low-fee, publicly traded funds may begin to accelerate.