A 40 Act fund is a pooled investment vehicle registered with the Securities and Exchange Commission under the Investment Company Act of 1940. The label covers mutual funds, closed-end funds, exchange-traded funds, and unit investment trusts — the four kinds of funds sold to the general public. Because these funds take money from ordinary investors, the 1940 Act subjects them to a detailed set of rules on board independence, leverage, liquidity, custody, and public reporting that private vehicles like hedge funds do not have to follow.
The Four Types of 40 Act Funds
Registration under the Investment Company Act applies to several structures, and the differences among them shape how you buy, sell, and hold shares.
Open-End Funds (Mutual Funds)
Open-end funds, usually called mutual funds, are the most common. They continuously issue new shares to incoming investors and redeem existing shares 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 buy or sell order placed during the day settles at the same end-of-day price.
Closed-End Funds
Closed-end funds raise a fixed amount of capital through an initial public offering and then list on a stock exchange. No new shares are created after the offering. Investors trade existing shares on the market, and prices can sit above the fund’s per-share asset value (a premium) or below it (a discount). Closed-end shares behave more like individual stocks than like mutual fund shares.
Unit Investment Trusts
A unit investment trust buys a fixed basket of securities and holds them until a set termination date. No portfolio manager actively buys and sells along the way. Investors purchase redeemable units and receive income from the underlying securities until 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 closed-end funds, but a creation-and-redemption mechanism keeps their prices in line with underlying holdings. Large financial institutions known as authorized participants are the only entities that deal directly with the fund. When an ETF’s market price drifts above its underlying value, authorized participants deliver the underlying securities to the fund in exchange for new ETF shares and sell those shares on the market; when the price falls below the underlying value, they do the reverse. That arbitrage keeps the trading price close to net asset value.
What Registration Actually Requires
Registering under the 1940 Act is not a formality. It commits the fund to a package of investor protections that touches nearly every part of how it operates.
Independent Board Oversight
Every registered fund must have a board of directors or trustees that oversees operations on behalf of shareholders. Federal law caps “interested persons” — those with financial or professional ties to the fund’s adviser or underwriters — at 60 percent of the board, meaning at least 40 percent must be independent.2Office of the Law Revision Counsel. 15 USC 80a-10 – Affiliations or Interest of Directors, Officers, and Employees Directors are elected by shareholders, and if too many seats are filled by appointment rather than election, the fund must hold a special election within 60 days.3Office of the Law Revision Counsel. 15 USC 80a-16 – Board of Directors
The board’s most consequential job is approving the investment advisory contract. Every advisory agreement must be in writing, describe compensation precisely, and be initially approved by a majority vote of shareholders. After the first two years, the contract renews annually — either by shareholders or by the board, with a majority of independent directors voting in favor at an in-person meeting. The contract must be terminable on no more than 60 days’ notice without penalty.4GovInfo. 15 USC 80a-15 – Contracts of Advisers and Underwriters
Shareholders also get a direct vote on fundamental changes: shifting borrowing or lending policies, moving from a diversified to a non-diversified strategy, concentrating holdings in a specific industry against the fund’s stated policy, or exiting the investment company business entirely.5Office of the Law Revision Counsel. 15 USC 80a-13 – Changes in Investment Policy
Fiduciary Duty of the Adviser
An investment adviser managing a 40 Act fund 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 the adviser to provide advice in the client’s best interest, seek best execution when trading, and monitor the portfolio on an ongoing basis. The duty of loyalty requires the adviser to eliminate conflicts of interest or fully disclose them so the client can make an informed choice.6SEC.gov. Commission Interpretation Regarding Standard of Conduct for Investment Advisers
Willful violations of the Investment Company Act, or materially misleading statements in registration filings or reports, carry criminal penalties of up to $10,000 in fines, up to five years in prison, or both.7Office of the Law Revision Counsel. 15 USC 80a-48 – Penalties The SEC can also bring civil enforcement actions.
Leverage and Diversification Limits
An open-end fund may borrow only from a bank, and right after borrowing it must maintain asset coverage of at least 300 percent — total assets at least three times the borrowed amount. If coverage slips below that, the fund has three business days to bring borrowings back in line. 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
A fund that calls itself “diversified” must keep at least 75 percent of total assets 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 outstanding voting securities.9Office of the Law Revision Counsel. 15 USC 80a-5 – Subclassification of Management Companies A fund that does not meet this standard can still operate, but it must call itself non-diversified and disclose that to investors.
Funds that use options, futures, or swaps must comply with SEC Rule 18f-4, which caps the portfolio risk derivatives can add. The default is a Value-at-Risk test: portfolio VaR generally cannot exceed 200 percent of a reference index’s VaR, or an absolute 20 percent of net assets if no suitable index exists, measured at a 99 percent confidence level over 20 trading days.10eCFR. 17 CFR 270.18f-4 – Exemption From Requirements of Section 18 and Section 61 for Certain Senior Securities Transactions
Liquidity and Custody
Open-end funds must run a liquidity risk management program under SEC Rule 22e-4, sorting each holding into one of four buckets based on how quickly it can be sold without moving the price: highly liquid (three business days), moderately liquid (up to seven calendar days), less liquid (sellable within seven days but slower to settle), and illiquid (not sellable within seven days without significant price impact).11eCFR. 17 CFR 270.22e-4 – Liquidity Risk Management Programs 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 forced sales.
Every registered management company must place its securities in the custody of a qualified bank, a member firm of a national securities exchange, or, under SEC-prescribed conditions, the fund itself. Custodians hold the actual securities and cash separate from the management company, and independent auditors and SEC staff can inspect the accounts.13Office of the Law Revision Counsel. 15 USC 80a-17 – Transactions of Certain Affiliated Persons and Underwriters
Public Disclosure
Every fund must produce a prospectus setting out its investment objectives, principal risks, and complete fee schedule. Open-end funds can also use a shorter summary prospectus that tells you how to reach the full statutory prospectus online, by phone, or by email, and includes the fund’s name, ticker, and date of first use.14eCFR. 17 CFR 230.498 – Summary Prospectuses for Open-End Management Investment Companies A more detailed Statement of Additional Information is available on request.
After you invest, the fund sends shareholder reports at least twice a year, with a balance sheet, itemized income statement, list of portfolio holdings with current values, and a breakdown of compensation paid to directors and officers. Audited financial statements go to the SEC annually.15Office of the Law Revision Counsel. 15 USC 80a-29 – Reports and Financial Statements of Investment Companies Quarterly portfolio holdings are filed on Form N-PORT, with the first- and third-quarter filings due within 60 days of the reporting period’s end.16Federal Register. Form N-PORT Reporting All of these filings are public through the SEC’s EDGAR database.
What Is Not a 40 Act Fund
Not every pooled investment vehicle carries this label. Hedge funds and private equity funds typically avoid registration by relying on exemptions in the same statute. The most common 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 applies to funds sold only to “qualified purchasers” — investors meeting high wealth thresholds — regardless of investor count.17Office of the Law Revision Counsel. 15 USC 80a-3 – Definition of Investment Company Because these funds are not marketed to retail investors, they face far fewer restrictions on leverage, liquidity, and disclosure. If a fund is described as unregistered, private, or accredited-investor-only, it is not a 40 Act fund and the protections above do not apply to it.
Fees You Will See
40 Act funds charge fees that directly reduce your returns, and several are capped by regulation. Sales charges are limited by FINRA rules; for funds that also pay 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 without a service fee. Combined sales charges on funds with no asset-based charge cannot exceed 8.5 percent of the offering price.18FINRA. FINRA Rule 2341 – Investment Company Securities
Many funds charge an annual distribution fee, commonly called a 12b-1 fee, to cover marketing and distribution. FINRA caps this 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.19FINRA. FINRA Notice to Members 97-48 On top of that, the fund pays a management fee to the investment adviser, which the board reviews annually as part of contract renewal.
How 40 Act Funds Are Taxed
Most 40 Act funds elect to be taxed as Regulated Investment Companies under Subchapter M of the Internal Revenue Code. RIC status lets the fund avoid corporate-level income tax, but only if it passes ongoing income and asset tests and distributes almost all of its earnings.
At least 90 percent of the fund’s gross income must come from dividends, interest, gains on securities sales, and similar investment-related sources. The asset test, checked quarterly, requires at least 50 percent of total assets in cash, government securities, securities of other RICs, or diversified holdings, and no more than 25 percent concentrated in the securities of any single issuer other than government securities or other RICs.20Office of the Law Revision Counsel. 26 USC 851 – Definition of Regulated Investment Company
A RIC passes its income through to shareholders without paying corporate tax, but it has to distribute substantially all of its earnings. Shortfalls trigger a 4 percent excise tax on the undistributed amount. To avoid the penalty, the fund generally distributes at least 98 percent of its ordinary income for the calendar year and at least 98.2 percent of its capital gain net income for the one-year period ending October 31.21Office of the Law Revision Counsel. 26 USC 4982 – Excise Tax on Undistributed Income of Regulated Investment Companies For you as a shareholder, that structure is why fund distributions arrive as ordinary income, qualified dividends, or capital gains rather than being trapped and taxed at the fund level first.