Understanding Investment Companies
An investment company is a corporation or trust formed to invest its shareholders' money in a portfolio of securities. Investment companies enable investors to pool their funds so as to minimize risk and maximize gain through diversification and professional management. Historically, investment companies were called investment trusts; now, however, most investment companies use the corporate form of organization.
Investment companies have been formed in Canada, Europe, Japan, and some Latin American countries, as well as in the United States.
Investment companies in the United States operate under regulations of the Securities and Exchange Commission. They may be 'open-end companies', commonly called "mutual funds", or 'closed-end companies'. Open-end companies promise to redeem outstanding shares on any business day and normally offer new shares to the public continuously. Thus the public buys shares from, and resells shares to, the fund. Closed-end companies, by contrast, do not redeem outstanding shares and seldom issue new shares after the initial offering. An investor seeking shares of a closed-end company must buy them from a shareholder wanting to sell out.
Investment companies frequently contract for investment advice from a 'management company'. The management company may advise a number of separate investment funds and may have participated in the formation of these funds. Management companies are compensated by an annual fee of about 0.5% of the fund's portfolio value.
Profits of an investment company, and thus of its shareholders, come from two main sources: 'investment income', consisting of dividends and interest received on securities in the company's portfolio, and 'capital gains', realized when securities in the portfolio are sold at a profit.
Most U.S. investment companies elect to be "regulated" under a provision of the Internal Revenue Code. Regulated investment companies do not pay corporate income taxes. They are regarded for tax purposes as a conduit for the benefit of their individual shareholders, each of whom is responsible for taxes on his share of income and capital gains received by the company.
Since the first mutual fund in the United States was formed in Boston in 1924, mutual funds have grown to the point where they manage tens of billions of dollars in assets. Because a mutual fund is open-ended, its shareholders are always able to liquidate their shares at current net asset value. Net asset value per share is the total net assets of the fund divided by the number of shares outstanding; it thus represents the current market value of the portfolio behind each outstanding share. Net asset value is normally calculated twice daily on all days the New York Stock Exchange is open, and it is carried in newspapers as the "bid" price.
Mutual fund shares are usually purchased from a securities dealer, who in turn obtains the shares through the fund underwriter. The offering, or "asked", price is net asset value at the time of purchase plus any sales charge (called "load"). For most funds, sales charges are about 7.5% to 8.75% of the offering price, with reductions for large purchases. A few funds, called 'no-load funds', sell shares directly to investors without a sales charge.
In most states, mutual funds offer investors the opportunity to purchase shares on a formal continuing basis. Such 'accumulation plans' provide for periodic purchase of shares over an extended time period, often 10 years. Accumulation plans may be voluntary, with no penalty for discontinuance, or they may be contractual. In the latter type, called 'front-end load', as much as half of the first year's payments may be deducted as sales charges for the entire contractual period.
Mutual funds pursue a variety of goals. 'Common stock funds' normally invest in a diversified portfolio of promising common stocks. Some common stock funds concentrate on a particular type of stock, such as "blue chips" or "growth stocks". 'Balanced funds' maintain a portion of their portfolio in common stocks and a portion in bonds or preferred stocks. Some funds hold only bonds and preferred stocks. 'Income funds' seek greater-than-average current income by investing in securities with relatively high dividend or interest yields. 'Specialized funds' concentrate on securities in a particular industry or within a single geographic area or country. 'Exchange funds', also called 'switch funds', allow an investor who is "locked in" to an existing stock investment by a large potential tax liability to shift into the diversified exchange fund and defer his capital gains tax until he liquidates the fund shares. No new exchange funds have been permitted since July 1967.
Other Types of Investment Companies
Closed-end investment companies are formed with objectives similar to mutual funds. More than 20 closed-end investment companies are listed on the New York Stock Exchange, and about 30 more are traded on other exchanges or in the over-the-counter market. Shares of closed-end investment companies may be purchased or sold in the open market through brokerage firms, and commission costs are similar to those on other common stock transactions. Price is determined by supply and demand and may be more or less than current net asset value.
A special type of closed-end fund is the 'dual-purpose', or 'leveraged, fund', formed of equal proportions of two separate classes of shares—"income shares" and "capital shares". Holders of income shares receive as cash dividends the investment income on the entire fund, but none of the appreciation. A minimum dividend rate is promised. Holders of "capital shares" receive all appreciation in the fund's portfolio, but none of the income. A shareholder in such funds can expect to receive twice as much return of the type sought as he would from a regular fund because he receives either income or appreciation (but not both) on an asset base twice his initial investment.
In addition to open-end and closed-end investment companies, the U.S. Federal Investment Company Act of 1940 authorizes 'face-amount certificate companies' and 'unit investment trusts'. The former sell savings contracts calling for periodic payment of a fixed amount by the investor into the trust and promising to return to the investor at maturity a specific face value equal to accumulated savings plus compounded interest. Unit investment trusts issue redeemable trust certificates, each of which represents a beneficial fractional interest in a specific bloc of securities deposited with the trustee.