If an investment product has the characteristics of a mutual fund, it should be regulated like one, according to the Investment Company Institute of Washington D.C.

In a 30-page letter and memorandum July 12 to the SEC, Craig Tyle, the ICI's general counsel, asked the SEC to consider regulating web-based portfolio products under the Investment Company Act of 1940 and the Securities Act of 1933.

In particular, the ICI cited the products of FOLIOfn of Vienna, Va. as among the first fund-like products developed that duck regulation under the 1940 and 1933 Acts.

"FOLIOfn's program augurs a trend - firms using the tools of information technology and the web to create and offer novel types of investment products that allocate fractional interests in pools of securities to individual investors in ways that previously were not cost efficient," Tyle said in his letter. "FOLIOfn appears to believe that ... it can avoid the advertising restrictions, disclosure requirements, self-dealing prohibitions, fee and sales charge limits and other basic characteristics of the regulatory pattern framed by the 1933 and 1940 Acts."

The ICI is appealing to the SEC because FOLIOfn and other similar web-based financial products represent a competitive threat to the mutual fund industry, said Nancy M. Smith, a vice president with FOLIOfn.

"I think they are concerned about the competitive pressure FOLIOs put on mutual funds," she said. "We offer a solution and I think they see that as a threat."

FOLIOfn's products allow investors to build their own basket of securities or select from a variety of pre-fabricated baskets. Because they can purchase fractions of shares of securities, investors can gain broader diversification with a minimal investment, similar to a mutual fund, Smith said. But, individual investors can customize their portfolios and decide whether they want to buy or sell securities, which gives them greater control of tax distributions compared to a mutual fund, she said.

The product is not a mutual fund, however, said Smith. The investors' ability to control all of the trades is what makes the product closer to a brokerage account than a mutual fund, she said.

"FOLIOfn's are not mutual funds. It's not even a close call," Smith said.

But several key product characteristics make FOLIOfn, and other firms that offer similar products, investment advisers, not broker dealers, the ICI contends in its letter and memorandum.

Because FOLIOfn is using its expertise to buy, sell and trade fractional shares, investors are buying, in effect, securities that are separate from the underlying securities in their portfolios, the ICI said.

"These features interweave investors' fortunes with the efforts and success of FOLIOfn, and investors in the Program will rely largely on FOLIOfn's efforts," said Tyle in his letter. "Such reliance is the hallmark of an investment contract,' which is a security under the 1933 Act."

And because FOLIOfn offers pre-fabricated baskets of stocks and matches investors with a selection of baskets that corresponds to their risk tolerance levels, the website is assuming the role of investment advisor and should be regulated under the 1940 Act, the ICI said in its memorandum.

The SEC has studied several web-based products and is reviewing the ICI letter and memorandum, said Cindy Fornelli, an adviser to Paul Roye, director of the division of investment management.

"In respect to these new types of products, we view them as an innovation in the marketplace and we obviously applaud innovation designed to assist investors," said Fornelli. "It's nice to see people using technology in innovative ways. You increase competition and make other parties sit up and take notice and maybe costs will be reduced. On the other hand, we need to look at and scrutinize the products ... we are trying to get our hands around the different permutations and understand what federal security laws may be implicated."

Numerous online fund-like products have cropped up in the past year, some that are regulated as broker-dealers and some that are regulated as investment advisors, Fornelli said.

Some websites that include online stock portfolio investing and fractional securities are Netfolio.com, BuyandHold.com, and Sharebuilder.com.

While BuyandHold.com allows investors to build their own portfolio of stocks, it does not offer pre-fabricated baskets of stock like FOLIOfn, said Peter Breen, CEO and co-founder of BuyandHold.com of New York. Because it is not offering baskets of stocks or any kind of advice, BuyandHold.com is clearly an online broker and not affected by the ICI's memo, he said.

But the ICI's stance against FOLIOfn is understandable, Breen said.

"How (FOLIOfn) can argue that what they are offering is not a mutual fund when you have a pre-described basket of stocks, one would have to wonder," he said.

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