Investment companies come in many different flavors in order to appeal to any investor no matter what they’re looking for. While they may exist to help people invest and make a profit, they aren’t one size fits all.
An investment company is a type of company designed to invest pooled capital from investors into financial securities. These securities may be stocks, bonds or any other type of asset class. The vast majority of investment companies are either closed-end or open-end funds, commonly known as mutual funds.
Because these types of companies invest money for shareholders, there are a number of financial regulations in place to protect investors from fraud and mismanagement. The biggest one investors should be aware of is the Investment Company Act of 1940. In it, the rules for how an investment company may invest its capital and how it should be managed are spelled out. They must be registered with the SEC (Securities and Exchange Commission) and be fully transparent to regulators in order to ensure that investors are fully protected.
To familiarize yourself with regulations governing the mutual fund industry, read about the Investment Company Act of 1940.
The Various Forms of an Investment Company
1. Mutual Funds (Open-end)
The most common form of an investment company is a mutual fund. If you have a 401(k), you’re probably already invested in at least one mutual fund, but you might not know what exactly they are or what they do.
A mutual fund is an investment vehicle that takes a pool of money collected by investors and uses it to invest in securities such as stocks or bonds. They are run by professional money managers who make decisions about what securities to buy or sell and make changes to allocations based on economic and financial analysis.
A mutual fund’s prospectus outlines its stated goals for its investors. And while money managers are able to make some changes to the fund’s holdings, they are still obligated to invest according to the fund’s stated purpose. For example, if you owned shares in the T. Rowe Price Blue Chip Growth Fund (TRBCX), your holdings would largely include companies listed as large-cap, blue-chip stocks. Management could switch out stocks as they see opportunities but won’t invest in things like small-cap foreign stocks in order to maintain the fund’s overall investment goals.
2. Mutual Fund (Closed-end)
A closed-end mutual fund has some similarities to the open-end structure but with some key differences. While open-end mutual funds trade once per day, closed-end funds trade like stocks and can be bought and sold throughout the trading day. They also only issue a single IPO in order to raise capital and have a fixed number of shares, whereas an open-end mutual fund constantly takes in new investors and may have a varying share count.
Both types come with active management, however, closed-end funds are more strict with how they are run. These types of funds are usually designed for one single purpose and don’t stray as much as open-end mutual funds. Investments in specific assets like municipals or sectors like utilities are common for closed-end funds.
3. Unit Investment Trust (UIT)
A unit investment trust (UIT) is a type of investment company that, unlike mutual funds, offers investors a fixed portfolio of stocks and bonds. Investors looking for an investment to hold for a longer period of time instead of something that can be traded may choose a UIT instead. Investors will be able to collect interest income from dividends and bonds but will only profit from capital appreciation when the UITs holdings fully mature.
A Note on ETFs
A relatively new type of an investment product known as an ETF (exchange-traded fund) is becoming increasingly popular with investors and is classified as an investment company just like mutual funds or UITs. They may come with active or passive management and are set up as an open-end fund. The main attraction of ETFs is that they are able to be traded like stocks on the open market and generally come with lower fees than mutual funds and UITs. For instance, the Vanguard Total Bond Market ETF (BND) comes cheaper than a similarly structured mutual fund like the Fidelity Total Bond Fund (FTBFX)
Investors should be careful when choosing an ETF to make sure it matches their investment objectives. An investor looking for active management may want to pick a mutual fund instead of an ETF that doesn’t hedge its portfolio or buffer investors from economic downturns.
Learn about the differences between mutual funds and ETFs here.
The Bottom Line
Investment companies are great for investors who want to get started in the market but don’t have the time or knowledge to trade themselves. Mutual funds and UITs come with an active management team to help hedge the portfolio against economic downturns and stay diversified. ETFs can also be a great way to add diversity to your portfolio, just make sure you don’t mistake them for investment companies in the same category as mutual funds and UITs. Overall, all four investment company types can be a great addition to any portfolio.
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