What are the three types of investment companies?

 What makes investment companies different?

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Investment companies have a fixed pool of assets which is not affected by the buying and selling of their shares. Open-ended funds such as unit trusts, OEICs and UCITS expand and contract when investors buy and sell their units.

 Independent board

Each investment company has a board of directors whose job is to look after your interests. Almost all of these boards are independent from the fund manager and so they can exert pressure to keep running costs down and keep the manager on the right path, or even replace the manager.

 You have a vote

As a shareholder, you have a say in how your company is run. You get to vote on important issues. You can attend shareholder meetings such as Annual General Meetings (AGMs) and ask questions.

 Liquidity

Managers of open-ended funds must be able to turn investments into cash in a hurry if investors decide they want their money back. Closed-ended funds such as investment companies have a more stable base because the number of shares in issue is usually fixed. With the freedom not to worry about short-term cash flows, investment companies have more freedom to invest in assets that cannot be sold in a hurry like property and private equity. The board of directors of an investment company can choose to issue new shares or buy them back but, because this is optional, they can also take a genuinely long-term view about the merits of an investment. Investment companies can also operate with low levels of cash and can even borrow money to invest – improving performance when returns exceed borrowing costs.

 Net Asset Values

Investment companies publish net asset values. The frequency usually depends on the ease with which a valuation exercise can take place. The net asset value (NAV) is the value of all the company’s investments, including cash, less the value of all the money it owes, and is usually expressed as a number per share. This is the same calculation used to work out the price of an open-ended fund.

 Discounts and premiums

The value of shares in an investment company is largely determined by supply and demand. If there are more shares than people want to buy, the price normally falls. If there is demand for more shares than are available, the price tends to rise. In each case the share price is likely to settle at a level where demand and supply are matched. This means that the share price can be lower than the net asset value – a discount – or higher than the net asset value – a premium.

 Gearing

Investment companies can borrow money. This is often referred to as gearing or leverage because, just like gears on a bicycle, it multiplies effort. For investment companies, gearing exaggerates performance. It is a two-way street, however, as gearing can magnify losses as well as enhance returns. Generally gearing adds risk. Most investment companies use gearing sparingly and many don’t use it at all.

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Funds are of two main types: registered investment companies and private funds.Registered investment companies

Registered investment companies are registered under the 1940 Act and subject to significant disclosure and ongoing compliance obligations. As registered investment company securities are also registered under the 1933 Act, they may be offered to the public.

Registered investment companies can be further divided into three categories: mutual funds, closed-end funds and unit investment trusts.

Mutual funds

Mutual funds (also known as open-end funds) are investment companies that sell shares on a continuous basis. Mutual fund shares are purchased directly from the fund or from a broker for the fund. The purchase price is equal to the fund’s net asset value per share, plus any sales charges or other upfront fees.

Investors liquidate their investments in a mutual fund by selling their shares back to the fund. The sale price is equal to the fund’s net asset value per share, minus any redemption or other fees.

Mutual funds pursue a wide variety of investment strategies. Stock funds, bond funds, index funds, money market funds and ETFs may all be organized as mutual funds.

Closed-end funds

Unlike a mutual fund, which offers share continuously, a closed-end fund sells a fixed number of shares in an initial public offering. The shares then trade in the secondary market at a price that may be greater or less than the fund’s net asset value. As closed-end fund shares are generally not redeemable, investors wishing to exit from their investment must generally rely on the secondary market to sell their shares.

An interval fund is a type of closed-end fund that is permitted to offer shares continuously at a price based on the fund’s net asset value and periodically offers to repurchase its shares from shareholders. Such repurchase offers are generally made every three, six or twelve months. The purchase price is based on the fund’s net asset value per share as of the date specified in the repurchase offer (generally, no more than 14 days after the date on which shareholders must submit their acceptance of the repurchase offer). As closed-end fund shares do not typically trade in the secondary market, investors must rely on the repurchase offers for liquidity.

Closed-end funds may invest in a greater amount of illiquid securities than mutual funds and, therefore, are the preferred form of organization for funds engaging in such investments.

Unit investment trusts

Unit investment trusts issue a fixed number of securities (“units”) as part of a public offering. Investors may redeem units upon request at their approximate net asset value.

A UIT will terminate and dissolve on a fixed date, which will be specified when the UIT is created. A UIT does not actively trade its portfolio. Instead, it will hold a more or less static portfolio until its termination date. Upon termination, a UIT’s portfolio is liquidated and the proceeds are paid to investors.

Private funds

Private funds differ from registered investment companies in that they are offered only to a limited number of financially sophisticated investors rather than to the general public. This allows private funds to avoid registering as investment companies under the 1940 Act or registering their securities under the 1933 Act. As a result, private funds avoid many of the ongoing reporting and compliance obligations imposed on registered investment companies. Common types of private funds include hedge funds, private equity funds and managed futures funds (also known as “commodity pools”).

In contrast to registered investment companies, which must always be organized within the United States, private funds are often organized in offshore jurisdictions for tax, regulatory and marketing reasons.

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