Mutual Funds

They are regulated under four federal statutes — the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act of 1940, and the Investment Advisers Act of 1940 — and they are among the most heavily tested investment products on the SIE, Series 7, and Series 65 examinations.

The Legal and Regulatory Framework

The Investment Company Act of 1940 is the primary regulatory statute governing mutual funds. It classifies open-end management companies — what the public calls mutual funds — as a distinct category of investment company, distinguishing them from closed-end funds and unit investment trusts. 

The 1940 Act requires every mutual fund to register with the SEC before offering shares to the public, imposes detailed requirements on the fund's governance structure including an independent board of directors, restricts the fund's ability to engage in affiliated transactions, limits leverage, requires diversification standards for funds that represent themselves as diversified, mandates specific redemption rights for shareholders, and imposes ongoing reporting and disclosure obligations.

The Securities Act of 1933 requires that mutual fund shares — like all securities offered to the public — be registered with the SEC and sold only by means of a current prospectus containing the material information investors need to make an informed investment decision. 

Mutual funds file their registration statements and prospectuses on Form N-1A, which requires disclosure of the fund's investment objective, principal investment strategies, principal risks, fee table, performance history, management information, and other material facts. 

The prospectus must be delivered to investors before or at the time of sale.

The Investment Advisers Act of 1940 requires that the investment adviser managing a mutual fund's portfolio be registered with the SEC and comply with the fiduciary standards and conduct requirements applicable to all registered investment advisers. 

The fund's investment adviser is the firm that makes the portfolio investment decisions — buying and selling securities within the fund — and is compensated through the management fee charged against fund assets.

The Revenue Act of 1936 established the pass-through tax treatment for mutual funds — a fund that distributes substantially all of its income and capital gains to shareholders each year is not taxed at the fund level, avoiding the double taxation that would otherwise apply if the fund paid corporate tax before distributing after-tax income to shareholders. 

This pass-through treatment, which requires compliance with the regulated investment company requirements of Subchapter M of the Internal Revenue Code, means that the character of income passes through to shareholders — qualified dividends remain qualified dividends, long-term capital gains remain long-term capital gains, and tax-exempt municipal bond interest remains tax-exempt when distributed to shareholders.

The Open-End Structure — How Mutual Funds Differ From Stocks

The open-end structure of mutual funds creates a fundamental difference from publicly traded stocks and closed-end funds in how shares are priced and transacted.

Every purchase of mutual fund shares creates new shares — new capital flows into the fund, new shares are issued to the investor, and the portfolio grows by the amount invested. 

Every redemption destroys shares — the fund sells portfolio securities or uses cash reserves to pay the redeeming investor, and shares are cancelled. The number of shares outstanding fluctuates continuously with investor activity. 

There is no fixed number of shares and no secondary market trading among investors.

Because investors buy from and sell to the fund itself rather than other investors, the transaction price is not determined by supply and demand between buyers and sellers as it is for exchange-listed securities. Instead, the price is always the net asset value — the per-share value of the fund's underlying portfolio — calculated at the close of each business day. 

Mutual fund investors receive the NAV calculated at the close of the trading day on which their purchase or redemption order is received, provided the order is submitted before the cutoff time — typically four PM Eastern Time when US markets close.

This forward pricing rule — receiving the next calculated NAV rather than the price prevailing at the moment of order submission — is a fundamental characteristic of mutual fund transactions codified in SEC Rule 22c-1 under the Investment Company Act. It prevents market timing abuse in which traders submit orders during the day and receive that day's already-known closing price.

Net Asset Value — The Calculation

Net asset value is the per-share value of a mutual fund's portfolio, calculated by subtracting the fund's total liabilities from the total market value of its assets and dividing by the number of shares outstanding.

NAV equals total assets minus total liabilities divided by shares outstanding.

Total assets represent the current market value of all securities held in the portfolio plus cash and receivables. Total liabilities include accrued management fees, accrued operating expenses, dividends payable, and other short-term obligations. The fund calculates NAV at least once each business day, typically using the closing prices of the securities it holds.

For a fund with two hundred million dollars in total asset value, five million dollars in liabilities, and ten million shares outstanding, NAV equals two hundred million minus five million divided by ten million, equalling nineteen dollars and fifty cents per share.

When a load fund charges a front-end load, the investor pays the public offering price — NAV plus the sales charge — not NAV alone. A fund with a nineteen dollar and fifty cent NAV and a five percent front-end load has a public offering price of nineteen dollars and fifty cents divided by one minus five percent, equalling nineteen dollars and fifty cents divided by 0.95, equalling approximately twenty dollars and fifty-three cents. The sales charge represents the difference between the public offering price and NAV, expressed as a percentage of the public offering price.

The Three Investment Company Types — A Critical Comparison

The examination curriculum requires candidates to distinguish among three categories of investment company defined by the Investment Company Act of 1940.

Open-end management companies — mutual funds — continuously issue new shares and redeem existing shares at NAV. Shares are priced daily at NAV. Transactions occur directly with the fund. There is no secondary market.

Closed-end management companies — closed-end funds — issue a fixed number of shares in an initial public offering and then list those shares for trading on a national securities exchange. 

After the IPO, shares trade between investors in the secondary market at market prices that may differ substantially from NAV — closed-end funds commonly trade at either a discount or a premium to NAV depending on investor sentiment, the fund's investment category, and market conditions. Unlike mutual funds, investors in a closed-end fund cannot redeem directly with the fund — they must sell their shares to other investors through the exchange.

Unit investment trusts are a third investment company category with a fixed, unmanaged portfolio and a set termination date. UITs issue redeemable units to investors, hold a fixed portfolio of securities without active management, and liquidate the portfolio and return proceeds to investors at the preset termination date.

Types of Mutual Funds by Investment Objective

Mutual funds pursue an enormous range of investment objectives, and candidates must understand the major categories. FINRA confirms that each mutual fund has a different investment objective and that some focus on particular products, industries, or regions while others replicate market indices.

Equity funds invest primarily in common stocks and seek capital appreciation, income, or both. Within equity funds, growth funds target companies with above-average earnings growth potential and typically pay little or no dividend income. Value funds target companies whose shares appear underpriced relative to fundamentals. Blend funds combine growth and value characteristics. Income equity funds prioritise dividend income. Sector funds concentrate in a specific industry — technology, healthcare, energy, financial services — accepting concentration risk in exchange for focused exposure.

Bond funds invest primarily in fixed income securities and emphasise income generation. Corporate bond funds, government bond funds, municipal bond funds, high yield bond funds, and international bond funds each reflect different credit and interest rate risk profiles as detailed in their prospectuses.

Balanced funds and asset allocation funds hold a mix of equities and fixed income, maintaining target allocations that provide built-in diversification across asset classes in a single fund.

Index funds replicate the composition of a market index — most commonly the S&P 500 — rather than relying on active portfolio management decisions. As confirmed by the SEC's investor education publication, index funds follow a passive investment strategy designed to achieve approximately the same return as a particular index before fees. Passive management produces less portfolio turnover, lower transaction costs, more favourable tax consequences from lower realised capital gains, and lower management fees than actively managed funds. Over long time periods, the empirical evidence consistently shows that passively managed index funds outperform the majority of actively managed funds in the same category after fees.

Target date funds adjust their asset allocation over time based on a target retirement year, automatically becoming more conservative — reducing equity allocation and increasing fixed income — as the target date approaches. They are widely used as default investment options in 401(k) plans and other defined contribution retirement plans.

The Prospectus and Summary Prospectus

Every mutual fund is required by the Securities Act of 1933 to provide investors with a current prospectus before or at the time of sale. The prospectus filed on Form N-1A discloses the fund's investment objective and principal strategies, principal risks, fee table showing all costs including management fees and twelve b-one fees, performance history compared to an appropriate benchmark, portfolio managers and their backgrounds, and procedures for purchasing and redeeming shares.

The summary prospectus — introduced by SEC amendments effective in 2009 — is a shorter, investor-friendly document presenting the most essential information from the statutory prospectus in a standardised format limited to a few pages. The summary prospectus satisfies the delivery requirement provided the full statutory prospectus is available on the fund's website and upon request. Investors may also review the statement of additional information — the SAI — which contains supplementary detail not required in the prospectus itself.

Diversification Standards Under the Investment Company Act

The Investment Company Act of 1940 establishes specific diversification standards that a fund must meet before it may represent itself as a diversified fund. Under these standards, at least seventy-five percent of the fund's total assets must be invested so that no single issuer represents more than five percent of the fund's total assets, and the fund does not hold more than ten percent of the outstanding voting securities of any single issuer. These seventy-five percent, five percent, and ten percent tests apply to the diversified portion of the portfolio — the remaining twenty-five percent may be more concentrated.

Funds that do not meet these standards are non-diversified funds, which must disclose their non-diversified status and the associated concentration risk in their prospectuses. 

Sector funds, country funds, and other concentrated strategies are typically classified as non-diversified. The Investment Company Act's diversification definition is narrower than the everyday use of the term — a fund can hold thirty different stocks and still be non-diversified under the 1940 Act if any single holding exceeds the prescribed limits.

Mutual Fund Transactions — Rules Governing Purchase and Redemption

Mutual fund purchase and redemption transactions occur directly between the investor and the fund, not through the secondary market. As a consequence, mutual fund transactions are primary market transactions — each purchase creates new shares and each redemption destroys shares.

Investors may not purchase mutual fund shares on margin — SEC regulations prohibit the purchase of primary market offerings on margin, and mutual fund shares are always offered in the primary market. Mutual fund shares also cannot be sold short — because each redemption destroys shares rather than borrowing them for future delivery, the short sale mechanism does not apply.

Redemption proceeds must be paid within seven calendar days of the redemption request under the Investment Company Act of 1940 — in practice, most fund redemptions are paid within one to three business days. This seven-day rule ensures that investors can access their capital promptly and is a key liquidity protection in the mutual fund structure.

Fees and Expenses

All mutual funds charge ongoing fees deducted from fund assets that reduce investors' net returns — the expense ratio is the total annual cost expressed as a percentage of average net assets. The expense ratio includes the management fee paid to the investment adviser, administrative expenses, and any twelve b-one distribution fees.

Sales loads — discussed in detail in the Load Fund entry in this dictionary — are charged by load funds at purchase (Class A shares — front-end load), at redemption (Class B shares — contingent deferred sales charge), or as a persistent annual level load (Class C shares — twelve b-one). No-load funds charge no sales commission, meaning the full purchase amount is immediately invested.

FINRA Rule 2341 limits the maximum aggregate sales charge that may be imposed by a mutual fund to eight and a half percent of the public offering price for funds offering rights of accumulation and dividend reinvestment, as discussed in the Load Fund entry.

Tax Treatment — Pass-Through Character

Mutual funds qualify as regulated investment companies under Subchapter M of the Internal Revenue Code by distributing substantially all income and capital gains to shareholders each year. This pass-through treatment means the fund itself pays no tax and shareholders are responsible for taxes on distributions.

Dividend distributions from a fund's equity holdings retain their character as qualified or ordinary dividends in the investor's hands. Interest distributions from a fund's bond holdings are taxable as ordinary income. Capital gain distributions from the fund's portfolio sales are taxable as long-term or short-term capital gains depending on how long the fund held the sold securities — not how long the investor has held the fund shares. Interest distributions from a municipal bond fund retain their tax-exempt character when distributed to shareholders.

Examination Relevance and Key Takeaways

Mutual funds are tested on the SIE, Series 7, and Series 65 examinations in the context of investment company types, NAV calculation, forward pricing, prospectus requirements, the Investment Company Act of 1940, fees and loads, and tax treatment.

The key points to retain are these.

A mutual fund is an SEC-registered open-end management company that continuously issues and redeems shares at NAV calculated daily. All transactions are primary market transactions directly with the fund — mutual fund shares cannot be purchased on margin and cannot be sold short. NAV equals total assets minus total liabilities divided by shares outstanding, calculated at least once each business day. The forward pricing rule under SEC Rule 22c-1 requires investors to receive the next calculated NAV, not the NAV prevailing when the order was submitted. 

The public offering price for load funds equals NAV divided by one minus the load percentage. Open-end funds differ from closed-end funds — which issue a fixed number of shares traded in the secondary market at prices that may differ from NAV — and from unit investment trusts — which have fixed unmanaged portfolios and set termination dates. Diversification under the Investment Company Act of 1940 requires that at least seventy-five percent of assets be invested with no more than five percent in any single issuer and no more than ten percent of any issuer's voting securities held. Mutual funds that comply with Subchapter M of the IRC are regulated investment companies entitled to pass-through tax treatment — distributions retain their character as dividends, interest, long-term capital gains, or tax-exempt interest when paid to shareholders. The prospectus filed on Form N-1A is required to be delivered before or at the time of sale and discloses the investment objective, principal strategies and risks, fee table, and performance history. Redemption proceeds must be paid within seven calendar days of the redemption request.