Investment Company Act of 1940 and Mutual Funds

The Investment Company Act of 1940 is the law that defines the rules under which a mutual fund operates. Mutual funds are one of several types of investment companies -- including closed-end funds and unit investment trusts -- covered under the act. The Investment Company Act gives you, as a mutual fund investor, peace of mind that you are not sending your money to some sort of scam or that fund managers will steal the money.

Open-End Investment Company

In the act, what are commonly called mutual funds are referred to as open-end companies. Open-end means the fund sells shares directly to investors and redeems shares that investors want to sell. In contrast, closed-end fund shares trade on a stock exchange, and the fund company does not sell additional shares or buy back shares from investors. Open-end is important, because an investor who wants to get out of a fund investment must have his share redeemed by the fund company, and he will receive the current market value of the shares.

Board of Directors

A mutual fund has a board of directors, as required by the Investment Company Act, to look out for the interest of fund investors. A mutual fund doesn't have employees, so the board hires outside parties to handle portfolio and administrative management. A major function of the board of directors is to oversee the fund's investment adviser, making sure the securities owned by a fund meet the investment objectives in the fund's prospectus. At least 75 percent of the board members must be independent of the companies that market or provide investment advice for the fund.

Custody of Assets

The Investment Company Act dictates that the assets of a mutual fund be held by an independent custodian, typically a bank. The separate custody of assets eliminates the possibility that the portfolio of a mutual fund would be raided by an investment adviser or portfolio manager. The act separates the different parties operating a mutual fund, providing a high level of investor protection. The investment adviser and portfolio managers determine what securities will be bought and sold. The custodian holds those securities, and the assets must be audited at least annually.

Securities and Exchange Commission

The Securities and Exchange Commission enforces the Investment Company Act of 1940. The SEC develops rules on how mutual funds operate, it makes sure a fund files the required disclosure documents, and it regularly inspects the books of the fund company. If a problem arises with a mutual fund, the SEC investigates the allegations and acts to make sure investor rights and account values are protected.