Exchange Funds: Regulated Investment Company Status Explained

A regulated investment company (RIC) is a company that is regulated by the Securities and Exchange Commission (SEC) and the Investment Company Act of 1940. To qualify as a RIC, a company must meet certain requirements, including registering as an investment company with the SEC and deriving a minimum of 90% of its income from capital gains, interest, or dividends. Exchange-traded funds (ETFs) are a type of investment fund that is traded on stock exchanges and are considered a type of RIC. Therefore, an exchange fund can be considered a regulated investment company if it meets the requirements set by the SEC and the Investment Company Act of 1940.

Mutual funds and exchange-traded funds (ETFs)

Mutual Funds

Mutual funds are investment schemes where money from multiple investors is pooled and invested in a variety of bonds, securities, and other instruments. They have been around for a century, with the first mutual fund launched in 1924. Mutual funds are usually actively managed, meaning fund managers make decisions about how to allocate assets to try and beat the market. These funds typically come with higher fees due to their higher operations and trading costs. Mutual funds can only be bought and sold at the end of each trading day, based on their net asset value (NAV). The NAV is the fund's price per share, calculated after the market closes.

Exchange-Traded Funds (ETFs)

ETFs are investment funds that are traded on stock exchanges, similar to individual stocks. They can be structured to track anything from commodity prices to a diverse collection of securities. ETFs are usually passively managed, meaning they track a market index or sector index rather than trying to beat the market. They are often cheaper to invest in than mutual funds, with no minimum investment requirements and lower expense ratios. ETFs can be bought and sold throughout the trading day, making them a better choice for active traders.

Regulation

Both mutual funds and ETFs are regulated by the Securities and Exchange Commission (SEC) and must comply with the Investment Company Act of 1940. Additionally, ETFs are subject to securities laws such as the Securities Exchange Act of 1934 in the United States. To qualify as a regulated investment company, mutual funds and ETFs must meet certain requirements, including deriving a minimum of 90% of their income from capital gains, interest, or dividends.

Real estate investment trusts (REITs)

REITs are typically traded on major stock exchanges and are considered a type of Regulated Investment Company (RIC). To qualify as a RIC, a company must meet certain requirements, including being structured as a corporation and deriving at least 90% of its income from capital gains, interest, or dividends.

There are two main types of REITs: Equity and Mortgage. Equity REITs own or operate income-producing real estate, while Mortgage REITs (mREITs) provide financing for income-producing real estate and earn income from the interest on these investments.

REITs offer investors several benefits, including high dividend yields, liquidity, and diversification. They have historically delivered competitive total returns and have a low correlation with other assets, making them an excellent portfolio diversifier.

However, there are also risks associated with investing in REITs, such as real estate risk, interest rate risk, occupancy rate risk, and geographic risk. It is important for investors to carefully consider these risks before investing in REITs.

Unit investment trusts (UITs)

A UIT typically makes a one-time public offering of a specific, fixed number of securities or units, like a closed-end fund. It issues redeemable units, like a mutual fund, meaning the UIT will buy back an investor's units at their approximate net asset value (NAV). However, unlike mutual funds, UITs are not actively traded, meaning securities are not bought or sold unless there is a change in the underlying investment.

A UIT is either a regulated investment corporation (RIC) or a grantor trust. A RIC is a corporation in which investors are joint owners, and a grantor trust grants investors proportional ownership in the UIT's underlying securities. UITs are subject to regulation by the U.S. Securities and Exchange Commission (SEC) and are registered with the SEC.

There are several types of UITs, each with a different investment strategy:

• Strategy Portfolio: This type of UIT aims to beat a market benchmark and outperform general investments.
• Income Portfolio: This type of UIT focuses on generating dividend income, often at the expense of capital appreciation.
• Diversification Portfolio: This type of UIT aims to diversify portfolio assets across a broad range of investments to minimize risks.
• Sector-Specific Portfolio: This type of UIT focuses on a very specific or niche market, though it is often higher risk.
• Tax-Focused Portfolio: This UIT invests in tax-benefit or tax-deferred investments, such as state-exempt or federal-exempt fixed-income securities.

UITs have several advantages, including providing investors with access to a diversified portfolio of securities, reducing the risk of losses due to the underperformance of a single security. They also offer greater transparency into their holdings and investment strategy through regular portfolio disclosures. UITs are also typically structured as pass-through entities, meaning they do not pay taxes at the trust level, resulting in greater tax efficiency. They often have low minimum investment requirements, making them accessible to a wider range of investors.

However, UITs also have some disadvantages. Due to their fixed portfolio of securities and set investment strategy, investors have little control over the investments made by the trust. They may also not provide the same level of diversification as more broadly diversified investments. UITs are designed to be long-term investments, so they may not be suitable for investors who need quick access to their funds. They may also incur upfront fees, making them more costly for investors.

Pass-through income and double-taxation

A regulated investment company (RIC) is a company that is regulated by the Securities and Exchange Commission (SEC) and the Investment Company Act of 1940. To qualify as a RIC, a company must meet certain requirements, including registering as an investment company with the SEC and deriving a minimum of 90% of its income from capital gains, interest, or dividends earned on investments.

One of the key benefits of a RIC is its ability to utilise pass-through or flow-through income. This structure allows the company to avoid double taxation, which would occur if both the investment company and its investors paid taxes on the company's income and profits. With pass-through income, only the individual shareholders are required to pay income tax on the profits passed through to them. This is also known as the conduit theory, as the investment company acts as a conduit for passing on capital gains, dividends, and interest to its shareholders.

By avoiding double taxation, RICs provide tax efficiency for investors. Without this structure, investors would be taxed twice on the same source of income, once at the corporate level and again at the personal level. Double taxation can also occur in an international context when income is taxed by two different countries. To mitigate this, many countries have signed tax treaties to avoid double taxation and promote international trade.

It is important to note that RICs must adhere to specific regulations and distribution requirements to maintain their status and avoid excise taxes. This includes distributing a minimum of 90% of their net investment income to shareholders in the form of interest, dividends, or capital gains.

Requirements to qualify as a Regulated Investment Company (RIC)

To qualify as a Regulated Investment Company (RIC), several requirements must be met. Firstly, the business must exist as a corporation or other entity that would typically be taxed as a corporation. Secondly, it must be registered as an investment company with the Securities and Exchange Commission (SEC) under the Investment Company Act of 1940. This registration is a crucial step towards becoming a RIC.

Additionally, the business must elect to be deemed a RIC by the Investment Company Act of 1940, provided its income source and diversification of assets meet the specified requirements. This includes deriving a minimum of 90% of its income from capital gains, interest, or dividends earned on investments. This is often referred to as the "gross income test".

RICs must also distribute a minimum of 90% of their net investment income to shareholders in the form of interest, dividends, or capital gains. This is to avoid an excise tax by the IRS and to maintain their status as a pass-through entity for tax purposes.

To qualify, a company must also meet certain asset requirements. At least 50% of a company's total assets must be in the form of cash, cash equivalents, or securities. No more than 25% of the company's total assets can be invested in securities of a single issuer, unless they are government securities or securities of other RICs.

These requirements ensure that a business meets the specific parameters to become a RIC and benefit from the associated tax advantages.

Frequently asked questions