Management companies in more detail
Open-end and closed-end management companies are the investment companies you’ll most often sell and supervise, with open-end funds making up the majority of that business. Unit investment trusts (UITs) come up occasionally, but management companies - open-end funds especially - are what you’ll encounter most in practice.
Changing investment policies
Changes to a fund’s fundamental investment policies, the ones its registration statement says can only be changed by a vote of the shares, must be approved by the voting shares. If you are investing in a growth mutual fund whose growth objective is a fundamental policy, for them to change to an income fund, a vote would be required. You might lose that vote, but, only after a majority of the voting shares approve could a mutual fund change a fundamental policy.
Reasoning for purchase
Many reasons people purchase mutual funds is because of the consistent distributions. Mutual funds generally will distribute quarterly income/dividend distributions, and annual capital gains distribution. If a distribution from a mutual fund is paid from any source other than the fund’s net income, it must be accompanied by a written statement disclosing the source of the payment. Remember, if it is a dividend distribution, that is coming from income: the part the fund reports as qualified dividends is taxed at long-term capital gains rates, and the rest is taxed at ordinary income rates. If it is a capital gains distribution, that means it is coming from money raised from profits of selling something for more than they purchased it for, then it would be capital gains taxed. Whether long-term or short-term capital gains depend on how long the mutual fund held it, not how long the investor held the shares of the mutual fund before distribution. A gain is long-term when the security was held for more than one year, and short-term when it was held for one year or less. A fund’s net short-term gains reach shareholders too, but not as capital gains distributions: they are paid as part of the fund’s ordinary dividends and are taxed at ordinary income rates.
All investors purchase from mutual funds at the Public Offering Price (POP). Only a broker-dealer with a sales agreement with the fund’s underwriter (in practice, a FINRA member firm) may buy shares below POP, at a discount called a concession - still above NAV. Retail investors, and firms with no sales agreement, pay the public offering price, with no concession. The concession is what gives the selling firm a profit motive to sell the shares to clients at POP.
All redeemable securities that are redeemed must be cashed out within 7 days of tender of the security. When an investor sells their mutual funds, or UIT back to the issuer, they will get their money within 7 days. Usually it’s faster, 7 is the most.
A redemption is also a sale for tax purposes. The taxable gain is the proceeds minus the cost basis of the shares redeemed, so neither the principal nor the earnings comes out first: redeeming half of the shares bought in a single purchase recovers half of the cost basis. When shares were bought at different prices, which shares were sold is settled by specific share identification, first-in first-out (FIFO), or the average basis of the shares.
Rule 12b-1
Open-end management investment companies cannot act as a distributor of their own securities except through an underwriter, unless the payments made by such company in connection with the distribution are made pursuant to a written plan, the 12b-1 plan. In most cases for the real world, we simply think of 12b-1 as the ongoing annual fees, deducted from the fund’s assets, that investors pay in addition to the up-front load most would be paying with open-end, mutual fund shares. The maximum can be 1.00%, which has a maximum of 0.75% for distribution and 0.25% for service fees. They can, and often are lower, they cannot be higher.
The plan must be initially approved by a majority of the entire board of directors and by a majority of the directors who are not interested persons and have no financial interest in the plan, the “uninterested board of directors”. If the plan is adopted after the fund’s shares have been publicly offered, as when an existing fund adds one, a majority of the outstanding voting shares must also approve it.
The plan will be reviewed quarterly by the board of directors, but it must be reapproved annually to continue. The vote to continue 12b-1 will require the majority of the entire board of directors along with a majority of those uninterested board of directors. Under the Investment Company Act, at most 60% of a fund’s board can be interested persons; that means at least 40% must be uninterested, and the test could phrase it either way. A fund that relies on a 12b-1 plan has to go further: a majority of its directors must be uninterested (Rule 12b-1(c); Rule 0-1(a)(7)).
The 12b-1 plan can be terminated with either a majority of those same uninterested board of directors, or a majority of the outstanding voting shares. Make sure to pay attention to the or, the others are all ands. Either the uninterested board, OR the shares can end it.
Exchange-traded funds (ETFs)
ETFs seem very much like closed-end funds in how they trade: ETFs and closed-end funds trade on exchanges, while open-end funds are redeemed by the open-end company. Unlike a closed-end fund, though, an ETF does not have a fixed number of shares. Large firms called authorized participants create and redeem ETF shares in large blocks, called creation units, by exchanging baskets of securities with the fund, which keeps the ETF’s market price close to its NAV. ETFs are registered as open-end funds, and a few are organized as UITs; an exchange-listed closed-end fund is a closed-end fund, not an ETF.
Some common examples of ETFs that track a broad index would be VOO which is the Vanguard S&P 500 ETF, and QQQ, Invesco’s ETF tracking the NASDAQ-100. Other exchange-traded products track a specific asset class or investment style instead of a broad index: GLD tracks the price of gold (it is a commodity trust that, unlike an ETF, is not registered under the Investment Company Act), and VTV, the Vanguard Value ETF, tracks value stocks (a style ETF).
ETFs are great for investors who know what they are doing, or for brokerage portfolios to help diversify at lower costs than mutual funds. ETFs fit naturally in a brokerage account because they trade on an exchange throughout the day like stocks, while mutual fund shares are bought from and redeemed with the fund at the next calculated price.
Inverse ETFs are where ETFs get interesting. Inverse ETFs are trying to track an index, or market, but on the opposite side. When the index goes down in value, these go up. They use shorts, futures, and options, along with other potentially complicated investments, to make these very precise instruments. If the DOW falls approximately 1% in a day, a DOW inverse ETF will rise approximately 1% that day; if the DOW rises 1% in a day, that same ETF will fall approximately 1% that day.
Leveraged ETFs are where ETFs start amplifying. They can be 2x or 3x an index or other market. If the DOW rises 2% in a day, a 3x DOW ETF will rise approximately 6% that day; if the DOW falls 2% in a day, that same ETF will fall approximately 6%. Leveraged and inverse features can be combined into inverse leveraged ETFs: a -2x DOW ETF will rise approximately 6% on a day the DOW falls 3%, and fall approximately 6% on a day the DOW rises 3%. Because leveraged and inverse funds reset daily, these multiples hold only for a single day’s move; over longer periods their returns can diverge meaningfully from a simple multiple of the index’s return. FINRA has said that leveraged and inverse ETFs that reset daily are typically unsuitable for retail investors who plan to hold them for longer than one trading session.