World War I changed the debtor/creditor relationship between the United States and Europe. The war destroyed much of Europe’s industrial base, pro- viding an opportunity for U.S. industry to expand dramatically into new mar- kets. After a post-war correction from 1920 to 1921 during which commodity prices declined from their war-infl ated price levels, the American economy entered a strong growth phase. Americans in the twenties had money to spend and money to invest. Just as important for the fund industry, 20 million Amer- icans had learned something about investing during the war, when the United States government had sold them Liberty Bonds, some with denominations as small as fi fty dollars.5
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A Brief History of Mutual Funds in the United States 15
The bull market of the twenties drew many Americans into investing directly in common stocks. Many, however, were attracted to the advantages of professional management, diversifi cation, and economies of scale that an investment trust offered (at least in theory). The result, as one study of the industry states, was that “…trusts came thick and fast. Investment trusts were formed by investment bankers, by brokers, by industrialists, by banks, and by trust companies.”6
While the organizational details varied from trust to trust, the investment trusts of the twenties fell into two basic types. The fi rst and most popular type resembled the British and Scottish investment trusts, or what we today call closed-end funds. The organizers established a company and sold shares (and sometimes bonds) to raise money to form the investment pool. Once the pool was formed, the company’s shares traded on a secondary market, just like
Shapers of the Industry: Edward G. Leffl er
Edward Leffl er, a midwesterner of Swedish descent, was working as a securities salesman in Boston in 1924 when he became the catalyst for one of the most important developments in the industry. During his six years of selling securities, Leffl er had never been satisfi ed with the way small investors were treated, and believed that Americans needed a mechanism via which Wall Street could help them get ahead fi nancially. After studying the investment trusts of the day, he came to believe that the ideal vehicle would be a pooled fund with four key attributes:
• it would be professionally managed;
• it would diversify its holdings to reduce risk;
• it would keep costs within tolerable limits; and
• it would redeem its customers’ shares at any time.
This last feature, redemption on demand, became the hallmark of the American open-end fund.
Leffl er promoted his ideas for three years, fi nally interesting the Boston brokerage fi rm of Learoyd, Foster, & Company enough that they hired him and formed the Massachusetts Investment Trust on March 21, 1924. Leffl er soon left the fund because its management did not initially allow redemption on demand, although they changed their minds shortly after Leffl er departed.
In 1925 Leffl er, who had started his own fi rm, launched a new fund called Incorporated Investors. For the next few years Leffl er traveled the country selling both Incorporated Investors and the concept of the open-end fund. Leffl er sold mutual funds on and off for the rest of his career, ending up in the 1930s selling the shares of another pioneering fund, State Street Research Investment Trust. He testifi ed at the SEC hearings in 1936, where he continued to demonstrate his concern for the welfare of the individual investor, concern which had done much to shape the industry itself.
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the stock of any other company. In the fi ve years leading up to 1929, 56 of these closed-end investment trusts were formed. At the time of the Crash, the 89 closed-end investment trusts open to the public held assets valued at about
$3 billion.7 By way of comparison, the total value of stocks on the New York Stock Exchange at the same time was $87 billion.
The other major type of investment company structure appeared for the fi rst time in the twenties: the open-end fund, sometimes called the “Boston- type” investment trust.8 A few open-end trusts had actually been formed before the twenties, but these had not been made available to the public. For example, the Alexander Fund, established in 1907, began as an investment for a small circle of friends (although it was eventually opened to the public). The Alex- ander Fund was open-end because its by-laws provided that participants could withdraw their units at any time and receive the net unit value as of that date.
The fi rst open-end fund to be offered to the public at its inception was the Massachusetts Investors Trust, founded in 1924. Within a year it had attracted 200 investors, whose 32,000 shares were worth $392,000.9 MIT today would be called a large-cap equity fund—it started out by investing in nineteen blue chip industrial fi rms, fourteen railroads, ten utilities, and two insurance companies. It sold at an effective sales charge of fi ve percent. Other open-end funds followed, but they lagged the closed-end funds in popularity—only 19 open-end funds had been established by 1929, with assets totaling a mere $140 million.10
The Crash of 1929 changed everything. Many of the closed end funds had indulged in risky, even abusive, practices that magnifi ed the effect of the stock market crash on their investors. A few trusts were nothing more than Ponzi schemes, outright frauds. Many of those that operated legally did things that today are illegal for good reason, including:
•
failing to disclose the holdings in the portfolio (so that the securities, and therefore the fund, could be valued at whatever price the fund managers wanted);•
borrowing money to infl ate the size of the fund and enhance the investor’s return via leverage (but exposing the shareholders to the loss of their stake to senior debt-holders); and•
purchasing securities not via arms-length transactions, but rather as favors to help insiders unload undesirable stocks.The speculation of the late twenties had driven up the prices of the closed- end funds even higher than it did the prices of the underlying stocks and bonds.
By mid-1929, the average closed-end trust was selling at a premium of almost 50 percent of the value of its portfolio of holdings.11
This combination of speculation, unsound practices, and leverage made the stock market crash even harsher for closed-end trust holders than it did for
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A Brief History of Mutual Funds in the United States 17 holders of common stock. Between the end of 1929 and the end of 1930, the stock market, as refl ected by the Dow Jones Industrial Average (DJIA), fell from 248 to 164, a 34 percent drop. At the same time, the closed-end funds declined from an average premium of 47 percent above net asset value to an average discount of 25 percent below net asset value—a drop of 72 percent (not counting the simultaneous drop in the net asset value itself). As a result, closed-end funds became poison to investors—not a single new one opened during the 1930s.
While the Crash defl ated the value of the open-end funds as well, it also demonstrated their strengths. The open-end funds’ own policy of redemp- tion upon demand at net asset value safeguarded them against many of the problems that devastated the closed-end funds. They couldn’t hold any large proportion of their portfolios in unmarketable securities, because they might have to sell them at any time to meet investor redemptions. They couldn’t borrow heavily for the same reason. And because their share price was always set at net asset value, speculation could not infl ate the price of fund shares to extravagant levels (beyond what it was doing to the prices of the underlying securities). As a result of these factors, open-end funds fared much better than closed-end funds. MIT, for example, lost 83 percent of its value between Sep- tember 1929 and July 1932, (as opposed to an 89 percent decline in the DJIA), but it gained investors and new money during that same period.
The Crash of 1929, traumatic as it was for so many people, served as a crucible for the fl edgling mutual fund industry. It exposed the structural fl aws that the roaring twenties mentality had fostered, and confi rmed the utility of properly managed and controlled funds. In particular, it demonstrated the fun- damental value of the open-end structure. As one historian has put it,
By providing shareholders with ready liquidity, redemption on demand made open-end funds more secure in an era of insecurity. There is no precedent for the open-end structure in Britain. It is a purely American invention, and one of the great innovations of the U.S. capital markets.12