Investment companies

For many people, finance can feel large, complicated, and intimidating. If you don’t want to research and manage investments on your own, an investment company can do that work for you.

Investment companies are financial institutions that invest customers’ money on their behalf. You may have heard of a mutual fund, which is one type of investment company. When you buy shares of a mutual fund, you pool your money with other investors, and financial professionals invest that pooled money according to the fund’s strategy. Products like mutual funds were created for investors who don’t have the time, knowledge, or desire to build and manage a portfolio themselves.

Investment companies have existed since the 1920s, but they weren’t formally defined and regulated until 1940. In the early 1900s, financial markets often lacked reliable information and were vulnerable to deceit and manipulation. During and after the Great Depression, lawmakers passed several regulations aimed at reducing fraud and improving market integrity. One of those laws was the Investment Company Act of 1940.

The Investment Company Act of 1940 defined what an investment company is and set rules for how these firms operate. In this chapter, you’ll learn the main types of investment companies, how they’re regulated, and how to think about suitability for different investors.

When the Investment Company Act of 1940 defined investment companies, it also created three categories:

Management companies are investment companies that manage customers’ money. There are open-end management companies, also called mutual funds, and closed-end management companies, also called closed-end funds. These two structures work differently, but both are designed to invest in a portfolio of securities with the goal of earning returns for shareholders.

Unit investment trusts (UITs) also invest customers’ money, but they hold fixed portfolios of securities that are not actively managed.

Last, face amount certificates are a category of investment company that is rarely used today. Historically, they were sometimes paired with older mortgage structures. In the past, some mortgages required borrowers to make interest-only payments during the loan term and then repay the entire principal in a single lump sum at the end. To help ensure the borrower could make that final principal payment, banks required ongoing payments into a face amount certificate. The certificate was designed to grow to the amount needed to repay the mortgage principal.

Because modern mortgages typically amortize (monthly payments include both interest and principal), face amount certificates are largely non-existent today. For the exam, you’ll usually only need to recognize that they’re one of the three investment company categories.