Investment Companies - Structure, Management and Operation of Mutual Funds
Board of Directors
A management investment company (mutual fund company) has a CEO, a team of officers and a board of directors. Each one of these entities is responsible for serving the interests of the shareholders. The primary responsibility of the officers and the board of directors is to handle the investment company's administrative matters.
The board of directors is elected by the investment company's shareholders. The board defines the type of funds that will be offered to the public. For example, it will suggest offering a selection of funds - growth funds, international funds, income funds and so on - to meet the investment needs of many individuals. It will also define each fund's objectives. The board will also approve and hire the investment advisor, transfer agent and custodian (defined below) for each fund.
The principal underwriter of a mutual fund is called a distributor, or more commonly, the sponsor. The sponsor has a written contract with the investment company that allows it to purchase fund shares at the current net asset value and resell the shares to the public at the full public offering price, either through outside dealers or through its own sales force. The contract with the mutual fund company is subject to annual renewal, but as long as the sponsor is distributing and marketing the shares in a satisfactory manner, there is no reason why the sponsor's contract should be discontinued.
The custodian is responsible for the possession of the securities purchased by the investment company for its portfolio. The custodian also handles most of the investment company's clerical functions. Once securities are transferred to the custodian for safekeeping, the custodian must keep the assets physically segregated at all times, restrict access to the account to officers and employees of the investment company, and allow withdrawal only according to SEC rules.
The board of directors hires an investment advisor to invest the cash and securities held in the fund's portfolio, implement the objectives outlined by the board, manage day-to-day trading of the portfolio, and handle other tasks that involve the tax implications of the share. For these services, the investment advisor is acting as a fund advisor or fund manager, and earns a management fee paid from the fund's net assets. Usually, the fund manager earns an annual percentage of the fund's value, plus an incentive bonus if he or she exceeds certain performance goals.
The mutual fund contracts with a transfer agent to issue, redeem and cancel fund shares, handle the distribution of dividend and capital gains to shareholders, and send out trade confirmations. In certain instances, the custodian will act as transfer agent. The fund company usually pays the transfer agent a fee for services rendered.
As mentioned before, the sponsor usually distributes shares of the mutual fund through dealers. The dealers purchase shares from the sponsor at a discount to the public offering price and fill their customers' orders. It is important to note that dealers cannot buy shares for their own inventory to sell at a later date. They may purchase shares to fill customer orders or for their own investment, but any purchase that occurs for a dealer's own investment must be redeemed when sold; it cannot be sold to an investor.
Restrictions on Mutual Fund Operations
The SEC prohibits a mutual fund from engaging in the following activities unless it meets strict financial and disclosure requirements:
- Selling securities short
- Buying securities on margin
- Participating in joint investment or trading accounts
- Distributing its own securities, except through a sponsor
Otherwise, the fund must disclose these activities and the extent to which it plans to participate in these activities in its prospectus.
Affiliated and Interested Parties
The 1940 act and its amendments identify two types of people, defined as affiliated and interested parties, who may influence the investment company's management and operations and whose actions must be regulated and restricted by the SEC. They may not borrow money from the investment company or sell any security or property to the investment company or companies the management company controls.
- An affiliated person is someone who controls an investment company's operations in any way.
- An interested person includes those individuals who have a relationship with an affiliated person that the SEC deems influential in matters of fund operation. These people would include immediate family members of affiliated parties, legal counselors, broker-dealers, and so on.
Furthermore, the board of directors must have 40% outside representation: that is, at least 40% of the board must be made up of individuals who do not have a position with, or affiliation to, the fund. This restriction includes anyone associated with the underwriter, investment advisor, custodian or transfer agent.