The Investment Company Act of 1940: 77 Years Later

On this day in 1940, President Roosevelt signed the Investment Company Act of 1940.  Previously, both houses of congress had approved the ’40 Act unanimously. The ’40 Act, is the primary source of regulations for the multi-trillion dollar investment industry. The ’40 act defined and regulated investment companies, and provides investors with protections against conflicts of interest, misappropriation of funds, excessive fees, and undisclosed risks.

As he signed the bill, President Roosevelt declared:

We have come a long way since the bleak days of 1929…. I have great hopes that the act which I have signed today will enable the investment trust industry to fulfill its basic purpose as a vehicle to diversify the small investors risk.

What is a ’40 Act Fund?

The investment companies that the 1940 Act protections apply to are known as 1940 Act Funds, or ’40 Act Funds Broadly speaking, there are three types of  ’40 Act Funds: Closed End Funds, Open End Funds, and Unit Investment Trusts. Open end funds and closed end funds are the most common type of investment company.

Open end funds are also known as mutual funds.   An open end fund by definition provides investors with daily liquidity at net asset value. Closed-end funds by definition are not redeemable on a daily basis. Instead, when an investor in a closed end fund wants to redeem shares, they sell them on a secondary market, at a market determined price.. Most, but not all closed end funds  trade on an exchange. The sponsors of closed end funds may also conduct tender offers to buy back shares from investors.

An open end structure can work well for highly liquid assets. Providing daily liquidity allows investors to stay invested , while maintaining the optionality of using cash in other places. However, mutual funds often forced sellers in volatile markets when investors rush to the exit. (It also doesn’t help that mutual funds typically settle in one day, and stock trades typically settle in three days).

For illiquid assets such as corporate bonds, leveraged loans, or real estate, a closed end structure is more appropriate. Placing a daily liquidity wrapper around a portfolio that is difficult to trade can be disastrous. One recent example was the Third Avenue Focused Credit Fund, which was forced to halt redemptions , and delivered catastrophic losses for investors.

A closed end fund structure can offer investors access to an illiquidity premium. Often higher yielding securities are extremely illiquid. By avoiding daily liquidity pressure, a closed end fund manager can take a longer view.

Between Closed End and Open End

However, many closed end funds historically traded at steep discounts to NAV. Unscrupulous fund sponsors abused the “permanent capital” aspect of managing a closed end fund, underperforming and overcharging for years at a time. If a fund trades at a discount, the rational thing for a shareholder minded manager to do is repurchase shares, thereby accreting greater value to shareholders that stay in. Alternatively, tendering for shares at NAV protects remaining investors while also allowing some investors to exit wihout suffering a discount.

In 1992, the SEC the SEC released a report   that concluded that the rigid delineation between “open end” funds, providing daily liquidity, and “closed end funds” , which do not offer daily liquidity, limited the ability of sponsors to offer innovative investment products to investors. In response, the SEC created the interval fund structure, which acts as a cross between an open-end and a closed-end fund.

This diagram from Griffin Capital, summarizes this relationship:

Closed End Funds, Mutual Funds, and Interval Funds

Interval funds offer investors the option to invest daily, while they only allow for periodic redemptions (typically quarterly).   Therefore interval funds have  the opportunity to invest in illiquid assets more suitable to long term investors.  Interval fund tender offers create some discipline on the asset manager, without the instability caused by daily liquidity.