Series 6 Study Textbook

How To Understand Mutual Funds On The Series 6 Exam
and become an Investment Company Representative

One of the keys to passing the series 6 exam is to make sure that you have a complete understanding of how mutual funds will be tested on the Series 6 Exam. This article which was produced from material contained in our series 6 textbook and will help you master the material so that you pass the series 6 exam.


What is the Investment Company Philosophy?

An investment company is organized as either a corporation or as a trust. Individual investors' money is then pooled together in a single account and used to purchase securities that will have the greatest chance of helping the investment company reach its objectives. All investors jointly own the portfolio that is created through these pooled funds, and each investor has an undivided interest in the securities. No single shareholder has any right or claim that exceeds the rights or claims of any other shareholder regardless of the size of the investment. Investment companies offer individual investors the opportunity to have their money managed by professionals who may otherwise only offer their services to large institutions. Through diversification, the investor may participate in the future growth or income generated from the large number of different securities contained in the portfolio. Both diversification and professional management should contribute significantly to the attainment of the objectives set forth by the investment company. There are many other features and benefits that may be offered to investors that will be examined later in this chapter.

What are the Different Types of Investment Companies?

All investment company offerings are subject to the Securities Act of 1933, which requires the investment company to register with the Securities Exchange Commission (SEC) and to give all purchasers a prospectus. Investment companies are also subject to the Investment Company Act of 1940, which sets forth guidelines on how investment companies must operate. The Investment Company Act of 1940 breaks down investment companies into three different types:

  • Face amount company
  • Unit investment trust (UIT)
  • Management Investment company (Mutual funds)

What is a Face Amount Company/Face Amount Certificates?

An investor may enter into a contract with an issuer of a face amount certificate to contract to receive a stated or fixed amount of money (the face amount) at a stated date in the future. In exchange for this future sum, the investor must deposit an agreed lump sum or make scheduled installment payments over time. Face amount certificates are rarely issued these days as most of the tax advantages that the investment once offered have been lost through changes in the tax laws.

What is a Unit Investment Trust (UITs)?

A unit investment trust (UIT) will invest either in a fixed portfolio of securities or a non-fixed portfolio of securities. A fixed UIT will traditionally invest in a large block of government or municipal debt. The bonds will be held until maturity, and the proceeds will be distributed to investors in the UIT. Once the proceeds have been distributed to the investors, the UIT will have achieved its objective and will cease to exist. A non-fixed UIT, also known as a contractual plan, will purchase mutual fund shares in order to reach a stated objective. Both types of UITs are organized as a trust and operate as a holding company for the portfolio. UITs are not actively managed and they do not have a board of directors of investment advisers. Both types of UITs issue units or shares of beneficial interest to investors, which represent as undivided interest in the underlying portfolio of securities. UITs must maintain a secondary market in the units or shares to offer some liquidity to investors.

What are Management Investment Companies (Mutual Funds)?

A management investment company employs an investment adviser to manage a diversified portfolio of securities designed to obtain its stated investment objective. The management company may be organized as either an open-end company or as a closed-end company. The main difference between an open-end company and a closed-end company is how the shares are purchased and sold. An open-end company offers new shares to any investor who wants to invest. This is known as a continuous primary offering. Because the offering of new shares is continuous, the capitalization of the open-end fund is unlimited. Stated another way, an open-end fund may raise as much money as investors are willing to put in. An open-end fund must repurchase its own shares from investors who want to redeem them. There is no secondary market for open-end mutual fund shares. The shares must be purchased from the fund company and redeemed to the fund company. A closed-end fund offers common shares to investors through an initial public offering (IPO), just like a stock. Its capitalization is limited to the number of authorized shares that have been approved for sale. Shares of the closed-end fund will trade in the secondary market in investor-to-investor transactions on an exchange or in the over-the-counter market (OTC), just like common shares.

What is the difference between an Open End Fund and a Closed End Fund?

While both open-end and closed-end funds are designed to achieve their stated investment objective, the manner in which they operate is different. The following is a side-by-side comparison of the important features of both open-end and closed-end funds and shows how those features differ between the fund types:


Feature Open End Closed End
Capitalization Unlimited continuous primary offering Single fixed offering through IPO
Investor may purchase Full and fractional shares Full shares only
Securities offered Common shares only Common and preferred shares and debt securities
  Shares are purchased
and sold
Shares are purchased from the fund company and redeemed to the fund company Shares may be purchased only from the fund company during IPO, then secondary market transactions between investors
Share pricing Shares are priced by formula:
NAV + SC = POP
Shares are priced by supply and demand
Shareholder rights Dividends and voting Dividends, voting, and preemptive

What is the Difference between a Diversified Fund and a Non-Diversified Fund?

Investors in a mutual fund will achieve diversification through their investment in the fund. However, in order to determine if the fund itself is a diversified fund, the fund must meet certain requirements. The Investment Company Act of 1940 has laid out an asset allocation model that must be followed in order for the fund to call itself a diversified mutual fund. It is known as the 75-5-10 test and the requirements are as follows:

75% - 75% of the fund's assets must be invested in securities of other issuers. Cash and cash equivalents are counted as part of the 75%. A cash equivalent may be a Treasury bill or a money market instrument.

5% - The investment company may not invest more than 5% of its assets in any one company.

10% - The investment company may not own more than 10% of any company's outstanding voting stock.

Example

XYZ fund markets itself as a diversified mutual fund. It has $10,000,000,000 in net assets and the investment adviser thinks that ABC Company would be a great company to acquire for $300,000,000. Since XYZ markets itself as a diversified mutual fund, they would not be allowed to purchase the company even though the price of $300,000,000 would be less than 5% of the funds assets. The investment company must meet both the diversification requirements of 5% of assets and 10% of ownership in order to continue to market itself as a diversified mutual fund.