A 40 Act fund is a pooled investment vehicle registered with the Securities and Exchange Commission under the Investment Company Act of 1940. That single statute is what makes a mutual fund a mutual fund, an ETF an ETF, and a closed-end fund a closed-end fund in the legal sense. It sets the governance rules, the disclosure requirements, the leverage limits, and the custody arrangements that any fund sold to the general public has to follow. If you own shares in a fund through a brokerage account or a retirement plan, you almost certainly own a 40 Act fund.
The Four Types
The Investment Company Act sorts registered funds by how they issue and redeem shares.
Open-End Funds (Mutual Funds)
Mutual funds continuously issue new shares and buy them back at the fund’s net asset value, calculated once at the end of each trading day.1Office of the Law Revision Counsel. 15 USC 80a-8 – Registration of Investment Companies Every purchase or redemption placed during a given day settles at that same end-of-day price. The fund grows when money flows in and shrinks when investors cash out.
Closed-End Funds
A closed-end fund raises a fixed pool of capital in an IPO and then lists on an exchange. No new shares are created afterward. Investors trade existing shares on the open market at prices that can sit above (a premium) or below (a discount) the fund’s actual per-share asset value. That makes closed-end shares behave more like individual stocks than like mutual funds.
Unit Investment Trusts
A UIT buys a fixed basket of securities, often bonds or stocks, and holds them until a set termination date. No manager is actively trading the portfolio. You buy redeemable units, collect income from the underlying holdings, and receive the proceeds when the trust winds down.1Office of the Law Revision Counsel. 15 USC 80a-8 – Registration of Investment Companies
Exchange-Traded Funds
ETFs trade on exchanges throughout the day like stocks, but a creation-and-redemption mechanism keeps their prices closely tied to the value of what they hold. Large institutions called authorized participants are the only parties that deal directly with the fund. When the ETF’s market price drifts above the underlying value, APs deliver a basket of the fund’s securities in exchange for new ETF shares and sell them into the market. When the price slips below, they do the reverse. That arbitrage keeps trading price and net asset value tightly aligned.
What Makes a Fund a 40 Act Fund
Not every pooled investment vehicle is registered. Hedge funds and private equity funds usually rely on exemptions inside the same statute to stay out of the 40 Act regime. The most common exemption covers issuers with no more than 100 beneficial owners that do not offer securities to the public, or up to 250 owners for qualifying venture capital funds. A separate exemption lets funds sold only to “qualified purchasers,” meaning investors meeting high wealth thresholds, avoid registration regardless of how many investors they have.2Office of the Law Revision Counsel. 15 USC 80a-3 – Definition of Investment Company
Because those exempt funds are not marketed to retail investors, they face far fewer restrictions on leverage, liquidity, and disclosure. A 40 Act fund is built for ordinary investors, so the full set of protections below applies.
Investor Protections Built Into the Law
Three overlapping mechanisms do the protective work: an independent-leaning board, an adviser bound by fiduciary duty, and a set of shareholder votes on the biggest decisions.
Every registered fund has a board of directors or trustees that oversees operations for shareholders. Federal law caps “interested persons,” meaning directors with financial or professional ties to the adviser or underwriters, at 60 percent of the board. At least 40 percent must be independent.3Office of the Law Revision Counsel. 15 USC 80a-10 – Affiliations or Interest of Directors, Officers, and Employees Directors are elected by shareholders.4Office of the Law Revision Counsel. 15 USC 80a-16 – Board of Directors
One of the board’s most important jobs is approving the investment advisory contract. That contract must be in writing, spell out all compensation precisely, and get an initial majority vote of shareholders. After the first two years it must be renewed annually, either by shareholders or by the board with a majority of independent directors voting yes at an in-person meeting. The contract also has to allow the board or shareholders to terminate it on no more than 60 days’ notice, without penalty.5GovInfo. 15 USC 80a-15 – Contracts of Advisers and Underwriters
The adviser itself owes a fiduciary duty to the fund and its shareholders under the Investment Advisers Act of 1940. That duty has two parts. The duty of care requires acting in the client’s best interest, seeking best execution when trading, and monitoring the portfolio over time. The duty of loyalty requires the adviser to either eliminate conflicts of interest or fully disclose them so the client can make an informed decision.6SEC.gov. Commission Interpretation Regarding Standard of Conduct for Investment Advisers
Some decisions are too fundamental to leave with the board alone. A fund cannot change its borrowing or lending policies, shift from diversified to non-diversified, concentrate in an industry contrary to its stated policy, or stop operating as an investment company without majority shareholder approval.7Office of the Law Revision Counsel. 15 USC 80a-13 – Changes in Investment Policy
Limits on Risk-Taking
The statute and SEC rules put several guardrails around what a fund can do with your money.
Borrowing
An open-end fund may borrow only from a bank, and immediately after borrowing it must have asset coverage of at least 300 percent. Total assets, in other words, have to be at least three times the borrowed amount. If coverage falls below that threshold, the fund has three business days to bring borrowings back down. Closed-end funds face the same 300 percent requirement for debt-based senior securities.8Office of the Law Revision Counsel. 15 USC 80a-18 – Capital Structure of Investment Companies
Diversification
A fund that calls itself “diversified” must meet a specific test. At least 75 percent of total assets have to sit in cash, government securities, securities of other investment companies, or other securities where no single issuer accounts for more than 5 percent of total assets or more than 10 percent of that issuer’s voting shares.9Office of the Law Revision Counsel. 15 USC 80a-5 – Subclassification of Management Companies A fund that fails the test may still operate, but it has to classify itself as non-diversified and tell you so.
Derivatives
Funds that use options, futures, or swaps have to comply with SEC Rule 18f-4, which limits how much portfolio risk derivatives can add. The default measure is a relative Value-at-Risk test: total portfolio VaR cannot exceed 200 percent of the VaR of a designated reference index, or 250 percent for certain closed-end funds. If no suitable index exists, an absolute test caps portfolio VaR at 20 percent of net assets (25 percent for those closed-end funds).10eCFR. 17 CFR 270.18f-4 – Exemption From Requirements of Section 18 and Section 61 for Certain Senior Securities Transactions
Liquidity
Open-end funds have to run a liquidity risk management program under SEC Rule 22e-4. Each holding gets sorted into one of four buckets based on how quickly it can be turned into cash without significantly moving its price:11eCFR. 17 CFR 270.22e-4 – Liquidity Risk Management Programs
- Highly liquid: convertible to cash within three business days
- Moderately liquid: more than three but no more than seven calendar days
- Less liquid: saleable within seven days, though settlement takes longer
- Illiquid: cannot be sold within seven days without significant price impact
No more than 15 percent of an open-end fund’s net assets may sit in illiquid investments.12SEC.gov. Investment Company Liquidity Disclosure Final Rule The cap exists so managers can meet redemption requests without dumping holdings at fire-sale prices.
Custody
To prevent theft or mishandling, a registered management company has to place its securities with a qualified bank, a member firm of a national securities exchange, or, only under conditions the SEC prescribes, the fund itself. The custodian keeps the securities and cash separate from the management company. Independent auditors and SEC staff can inspect the records periodically to verify that everything is properly accounted for.13Office of the Law Revision Counsel. 15 USC 80a-17 – Transactions of Certain Affiliated Persons and Underwriters
Fees You Pay
40 Act funds charge a mix of fees, and several of them have hard ceilings under FINRA rules. These costs come directly out of your returns.
Sales charges, the fees you pay when buying or selling shares, are capped. For funds that also charge an ongoing asset-based distribution fee, the maximum front-end or deferred sales charge on a single transaction is 6.25 percent of the amount invested, or 7.25 percent if the fund does not pay a service fee. For funds without an asset-based charge, combined sales charges cannot exceed 8.5 percent of the offering price.14FINRA. FINRA Rule 2341 – Investment Company Securities
Many funds also charge an annual distribution fee, commonly called a 12b-1 fee, to cover marketing and distribution. FINRA caps that asset-based sales charge at 0.75 percent of average annual net assets, with an additional service fee capped at 0.25 percent, for a combined maximum of 1 percent per year.15FINRA. FINRA Notice to Members 97-48 On top of that, funds pay a management fee to the investment adviser. The board reviews this fee every year when it renews the advisory contract.
What You’re Entitled to See
Transparency is a defining feature of the 40 Act regime. You get multiple layers of disclosure before and after you invest.
Prospectus and Statement of Additional Information
Every fund produces a prospectus setting out its investment objectives, principal risks, and complete fee schedule. Open-end funds may also use a shorter summary prospectus containing the most critical information. The summary has to tell you how to get the full statutory prospectus online, by phone, or by email, and it must include the fund’s name, ticker, and date of first use.16eCFR. 17 CFR 230.498 – Summary Prospectuses for Open-End Management Investment Companies A more detailed Statement of Additional Information, covering fund history, management, and operational policies, is available on request.
Ongoing Reports
Once you invest, the fund has to send you reports at least twice a year. Semiannual shareholder reports include a balance sheet, an itemized income statement, a list of portfolio holdings at current values, and a breakdown of compensation paid to directors and officers. The fund also files annual reports with the SEC containing audited financial statements.17Office of the Law Revision Counsel. 15 USC 80a-29 – Reports and Financial Statements of Investment Companies
Quarterly, funds disclose their complete portfolio holdings on Form N-PORT. The first- and third-quarter filings include a full schedule of holdings under SEC accounting standards, due within 60 days of the end of the reporting period.18Federal Register. Form N-PORT Reporting All of these filings are public through the SEC’s EDGAR database.
Tax Treatment
Most 40 Act funds elect to be taxed as Regulated Investment Companies under Subchapter M of the Internal Revenue Code. RIC status lets a fund avoid corporate-level tax, but only if it passes two ongoing tests and distributes nearly all of its income to shareholders.
The income test requires at least 90 percent of gross income to come from dividends, interest, gains on securities sales, and similar investment sources. The asset test, checked at the end of each quarter, has two prongs. At least 50 percent of total assets must be in cash, government securities, securities of other RICs, or other securities where no single issuer represents more than 5 percent of total assets or more than 10 percent of that issuer’s voting shares. And no more than 25 percent of total assets may be concentrated in a single issuer other than government securities or other RICs.19Office of the Law Revision Counsel. 26 USC 851 – Definition of Regulated Investment Company
A qualifying RIC passes income through to shareholders without paying corporate tax, but it has to distribute substantially all of its earnings to keep that treatment. A shortfall triggers a 4 percent excise tax on the undistributed amount. To avoid the penalty, a fund generally has to distribute at least 98 percent of ordinary income for the calendar year and at least 98.2 percent of capital gain net income for the one-year period ending October 31.20Office of the Law Revision Counsel. 26 USC 4982 – Excise Tax on Undistributed Income of Regulated Investment Companies That distribution requirement is why fund shareholders receive year-end dividend and capital gains payouts.