And yet, most investors have no idea about it or how it functions. It should not be overlooked, as the Investment Company Act of 1940 really is the backbone of how most of us save for retirement or other goals. Understanding its basic tenets should be required reading for anyone looking to add mutual funds to their portfolio.

Be sure to also see the 7 Questions to Ask When Buying a Mutual Fund

To understand the Investment Company Act of 1940, first we need to understand what was going on during the time period when it was launched. Wall Street was sort of like the “Wild West,” as it was somewhat unregulated, which led to scams. The build-up of speculative bets—along with other factors—led to the stock market crash of 1929 and the resulting Great Depression. Confidence in the financial system was rattled and investors of all stripes were bailing on the U.S. Something had to be done.

In response to these two major economic events, Congress wrote into law the Securities Act of 1933 and the Securities Exchange Act of 1934 in order to regulate the securities industry in the interest of the general public. That gave birth to the SEC and now commonplace items, such as quarterly filings and prospectuses.

However, there were still some issues that needed to be addressed further.

Investment companies (closed-end funds and regular open-end mutual funds) were still a relative novelty at the time. In order to get the general investing public interested in these vehicles, Congress wrote up the Investment Company Act of 1940 and gave power to the SEC to enforce its attributes. It was here that the modern mutual fund industry really took shape.

Passed on August 22nd, 1940, the new act specifically spelled out what kind of activities investment companies could undertake and gave standards for the industry. The basics of the legislation describes investment companies’ functions and their structure, regulates various transactions among affiliated persons, outlines accounting, recordkeeping and auditing requirements of funds, and describes how securities may be redeemed and repurchased.

The act also specifically defined what a mutual fund was – something that hadn’t actually been done prior to 1940. Ultimately, the bill was designed "to mitigate and eliminate the conditions which adversely affect the national public interest and the interest of investors.” It does this in several ways.

First, all investment companies must register with the SEC. This provides necessary oversight. Secondly, each investment company must have a board of directors, and 75% of those board members must be independent or not affiliated with the fund’s activities. Again, this is designed to protect investors and provide impartial oversight of the fund.

In terms of actually operating the fund, the Investment Company Act of 1940 requires that funds limit the use of leverage and must include a cash buffer—in the case of mutual funds—for those investors wishing to redeem their shares at any time. In addition, funds under the act must disclose their structure, financial condition, investment policies and other objectives to investors via quarterly reports and updates. The N-SAR form—which holds all of this information as well as expense ratios and other operating facts—can be accessed free of charge through the SEC’s online EDGAR database.

All in all, the Act’s rules and regulations are intended to make sure that funds are acting in their investors’ best interests in order to minimize conflicts. However, the SEC does not make the distinction between “good” and “bad” investments. Picking the wrong mutual fund could still result in major losses.

Furthermore, not every investment trading on the market is classified under the Investment Company Act of 1940. Many hedge funds are able to skirt the rules by using what’s called a 3©1 or 3©7 exemption. Those rules require that funds have either less than 100 or less than 499 investors who meet certain standards. This allows hedge funds to use leverage and make exotic bets. Secondly, many commodity pools—like the iShares S&P GSCI Commodity-Indexed Trust (GSG)—are not regulated under the Act. The same goes for various managed futures funds, special purpose vehicles (SPVs), and other foreign investment funds.

After the Great Recession and Credit Crisis of 2008/2009, the Dodd-Frank Act of 2010 added some extra ammunition to the original Investment Company Act of 1940. Most of the new regulations focus on hedge fund oversight as well as provisions for financial advisers recommending mutual and hedge funds. Again, the new act was designed to limit systemic risk within the investment company world. However, the average stock or bond-based mutual fund was unaffected by Dodd-Frank aside from tightening down on potential leverage usage.

Quite simply, if the Investment Company Act of 1940 was never passed, we wouldn’t have the mutual fund industry we see today. The emphasis on disclosure and minimizing conflicts of interest helped spring forth the vehicle as the prime way the average investor builds wealth. Getting rid of the “snake-oil” salesmen and giving investors a standardized product allowed mutual funds to find their way into 401(k)s and other accounts.

While mutual funds continue to evolve, the Act still provides a legal framework for protecting the average investor from fraud. That makes the Investment Company Act of 1940 one of the most important pieces of legislature in Wall Street’s history.

While it’s not the only piece of regulation governing Wall Street, the Investment Company Act of 1940 certainly affects our portfolios in the biggest way. Providing the necessary oversight, checks and balances, and requirements for mutual funds and other investment vehicles, the Act basically allows investors to sleep at night, knowing that their investments are safe from fraud. All in all, it could be considered the single most important piece of regulation for the average investor.