An investment company is a company or trust whose main business is investing money raised from its shareholders in securities. Instead of making goods or lending to customers, it owns a portfolio of stocks, bonds or other financial assets, and its shareholders share in the results. Most of the familiar products sold to the public as funds, including the mutual fund, the closed-end fund and most exchange-traded funds (ETFs), are investment companies in law.
The term has a precise legal meaning in the United States, where the Investment Company Act of 1940 defines it, sorts investment companies into types and requires most of them to register with the Securities and Exchange Commission (SEC). Elsewhere it is used more loosely: in the UK an "investment company" usually means a listed investment trust, while the EU regulates the same activity through the UCITS and AIFMD fund rules. "Investment fund" is the broader, everyday umbrella term.
Investment company in plain terms
Most companies make or sell something: cars, phone plans, loans. An investment company's only product is its own portfolio. Its "factory" is a list of shares and bonds, and its "profit" is whatever that list earns in interest, dividends and price rises, minus the cost of running it.
Buying a share in an investment company is like buying a share of a well-stocked pantry that someone else manages. You do not pick each item yourself, but you own a slice of the whole thing. Because so many ordinary savers own these pantries, the law requires them to be open about what is inside and how much the manager charges.
The legal definition under the 1940 Act
Section 3(a)(1) of the Investment Company Act treats an issuer as an investment company if it is, or holds itself out as being, primarily engaged in investing, reinvesting or trading in securities. It also catches companies that own "investment securities" worth more than 40% of their total assets (leaving out government securities and cash), unless an exception applies. This 40% test is why operating businesses with large cash or securities holdings sometimes need legal advice to avoid falling under the Act by accident.
The Act then imposes strict rules on registered investment companies: independent directors on the board, limits on borrowing and leverage, bans on most dealings between the fund and its insiders, custody of assets with a qualified fund custodian, daily or regular valuation, and full disclosure in a prospectus.
The three types of investment company
The SEC and its investor website describe three basic types of registered investment company:
- Open-end funds (mutual funds). They continuously issue and redeem shares at net asset value. Money market funds and most ETFs are open-end funds.
- Closed-end funds. They issue a fixed number of shares, typically in an initial public offering, that then trade on an exchange at market prices, which can sit at a premium or discount to NAV. Interval funds and business development companies (BDCs) are related closed-end structures.
- Unit investment trusts (UITs). They buy a largely fixed portfolio, issue redeemable units and end on a set date. Some of the earliest and largest ETFs, such as the SPDR S&P 500 ETF Trust launched in 1993, are UITs.
Strictly, Section 4 of the Act names three classes in slightly different terms: face-amount certificate companies (now very rare), unit investment trusts and management companies. Section 5 then splits management companies into open-end and closed-end, and into diversified and non-diversified. The SEC's three-way grouping above is the practical version.
Exclusions: private funds and others
Many pooled vehicles are investment companies in substance but avoid registration through exclusions in Section 3(c). The two most important are Section 3(c)(1), for funds with no more than 100 beneficial owners that do not make a public offering, and Section 3(c)(7), for funds sold only to "qualified purchasers" (broadly, individuals with at least $5 million in investments). Most hedge funds, private equity funds and venture capital funds rely on one of these, which is why they can use high leverage, lock up investor money and charge performance fees that registered funds cannot. Their managers are still usually regulated as an investment adviser.
Other exclusions cover banks, insurers, broker-dealers and certain pooled accounts such as commingled funds run by bank trust departments for retirement plans.
Taxation and outside the US
A registered US investment company that meets the Internal Revenue Code's tests for a regulated investment company pays little or no corporate tax, provided it distributes at least 90% of its income. Shareholders are taxed instead, on each dividend and capital gains distribution they receive.
In the UK, investment trusts are listed public companies that invest in other companies' shares; they are closed-end, can borrow and are overseen by the Financial Conduct Authority (FCA) and their own boards. In the EU, open-end retail funds are authorised under the UCITS Directive and other funds under AIFMD. Whatever the label, investors judge these vehicles on the same basics: strategy, expense ratio, track record and the quality of the people running them, set out in documents such as the fund fact sheet.