Series Trust

What form of organization do mutual funds and ETFs have?

Mutual funds and ETFs are organized and registered pursuant to the Investment Company Act of 1940. The 1940 Act was designed as a specialized form of corporate entity. Unlike C corporations, 1940 Act funds and ETFs are not taxed at the corporate level so long as capital gains and investment net income are distributed to shareholders.

What are business trusts?

A business trust is sometimes called a “common law corporation”, a derivation of English common law. Operationally and from a tax standpoint business trusts are identical to other corporate structures. While the term “trust” can be confusing, since most people associate trusts with assets held “in trust” for beneficiaries, a business trust is similar in that it is established for the benefit of its investors. Massachusetts and Delaware business trusts are very common forms of mutual fund and ETF corporate organization.

What is a series trust?

A series trust is an investment company organized as a business trust that has more than one underlying series. An apt comparison is a holding company, where a parent company has multiple underlying subsidiaries. A series trust is a parent business trust, with underlying mutual funds or ETFs as series of the business trust. Each series operates autonomously, but many of the agreements for operations are between the trust and the vendor on behalf of some or all of the underlying series. Custody agreements, distribution agreements, engagement of outside counsel, engagement of independent auditors, purchase of insurance, and many state blue sky filings can be undertaken by the business trust on behalf of the underlying series.

Why are funds set up as trusts rather than companies when it is called the Investment Company Act?

The Investment Company Act of 1940 was passed to regulate entities that buy and sell publicly traded investment offerings. It governs the organization and activities of mutual funds and ETFs.  The first mutual funds were set up in Massachusetts in the 1940s. Massachusetts corporate law makes significant use of business trusts, reflecting the heritage of English common law.  The term “trust” can be a bit misleading as a “business trust” is not quite the same structure as many people think of the term trust, like a charitable remainder trust or trust for children or grandchildren. A business trust does exist for the benefit of its investors. In the late 1980s Maryland adopted an amendment to its corporate law to specially accommodate mutual funds, given the significant presence of mutual funds companies domiciled in Maryland. Shortly thereafter Delaware, a state well-known for its corporate organizations and domicile, used the prototypes of Massachusetts and Maryland to adopt a Delaware Business Trust form of organization for investment companies. All three forms of organization are widely used. Nottingham has used Delaware business trusts for over 20 years.

How many series can be in a trust?

Theoretically an unlimited number of series can be organized within a single business trust. From a practical matter, however, there is a limit on what the Board of Trustees can oversee effectively while exercising prudent business judgment. Anyone who has participated on any governing board knows there is a point of diminishing return, where one’s eyes begin to glaze over, and it is time to go home and rest. A board of trustees overseeing a mutual fund or ETF is no different. Most series trusts, therefore, limit the number of funds to a number that is manageable yet efficient. A large series trust may have 25-30 mutual funds or ETFs in the same series trust.

What is a standalone trust versus a series trust?

An investment company can be organized with just one series. For some issuers this is a preferred approach. There are pros and cons, which we will explore below. A standalone trust requires filing the initial forms with both the state of organization, an organizational board meeting, and initial filings with the SEC to establish the new investment company. Each of these steps involve additional time and expenditures, but there can certainly be advantages to the de novo organization.

Can a mutual fund be set up in any state?

A mutual fund can be set up in any state, but the most common states of organization are Delaware, Massachusetts, and Maryland.

There is no legal reason that prohibits forming an investment company in any of the 50 US states, although most states’ base corporate law is not as conducive to investment companies as the three primary states of organization.

What is the governance structure of an investment trust?

Whether established as a business trust or a corporation, an investment company is governed by an independent board of directors or trustees. The Investment Company Act of 1940 and SEC case law and practice proscribe specific review processes that directors and trustees are expected to honor and follow. Meetings must typically be held at least quarterly. Several items governed by the board must be approved annually in person. The SEC conducts periodic field audits of investment companies and their board minutes and other records to ensure those practices are being undertaken, to protect the public shareholders.

Why is a series trust better than or preferable to a standalone trust?

Operating a mutual fund or an ETF entails some significant expense. Some of the largest expenses are legal costs of governance, and filings fees and expenses. In a series trust some of these expenses can be shared among the series within the trust, which results in considerable savings per fund or ETF.  Other expenses such as insurance can be significantly more expensive to purchase on a standalone basis than purchasing a shared policy.

Why is a standalone trust better or preferable to a series trust?

Although there is a shield of liability which segregates each mutual fund or ETF from the other series within a series trust, there is still a theoretical possibility the assets of one fund could be called to satisfy another fund’s liabilities. This is highly unlikely, but theoretically possible. Some portfolio managers prefer the perception and autonomy of not having other parties involved with decision making and perhaps policy direction. An existing series trust has its own existing board of trustees, while a new mutual fund or ETF may prefer to invite its own slate of directors or trustees.