The Economic Role Of The Investment Company

February 28, 2012

The Economic Role Of The Investment Company

If you asked experts in the financial industry what single individual has done the most in the past 50 years to influence how Americans invest, you’d get a wide-ranging list of names—but one name you’d see over and over would be John Bogle. What follows are excerpts from his 1951 college thesis, submitted to Princeton University, including parts of Chapter 1, “Advantages to the Individual Investor,” and the conclusion. In it, you can see the original seeds of many of the ideas and concerns that would later drive him to build the Vanguard Group and become an outspoken advocate for the best interests of investors.

That the investment company has fulfilled its functions to the individual investor appears manifest. The very fact that the number of shareholders has trebled in the last ten years seems to indicate that they have found it a suitable means to accomplish their investment ends.1 It will be the place of this chapter to show what advantages the investment company gives the investor, using particular examples wherever practicable.

Several things must be made clear, however. First, investment companies have generally tried to encourage the purchase of their shares by investors, not savers. Many funds point to the need for adequate cash reserves, insurance, and perhaps additional savings or government bonds before placing the remainder in a mutual fund. This chapter, then, will be oriented toward those individual investors who can afford investment, which by its very nature entails a certain amount of risk.

Second, the funds can make no claim to superiority over the market averages, which are in a sense investment trusts with fixed portfolios; e.g., the stocks composing the particular “average.” They state, rather, that their performance must be judged against what the individual could have done at the same cost over the same period, with the same objectives as has a given fund.

Third, it is evident that the open-end investment company cannot attain perfect fulfillment of all the objectives stated below, but makes available the most adequate combination of facilities for the individual investor; that is, it offers the package with the greatest total amount of management, diversification, income, liquidity, and dollar appreciation. There will be no claim in this thesis that the management of the investor’s capital will produce better results than that of an investment counsel who handles large accounts individually; that the diversification will be sounder than that of insurance companies under legal list requirements; that the income will be as stable as that of government bonds or as high as that from a given common stock; that the liquidity will be as great as that given by a savings bank; nor that the share will appreciate in value with the cost-of-living as a closed-end leverage share does. The only claim will be that the investment company offers the best combination of these facilities to the individual investor.

In offering to the investor a greater degree of diversification and more expert management than he could otherwise obtain, investment companies present a wide variety of fund types with diversified objectives, from which the investor may choose. He may pick the balanced fund, which attempts to plan its portfolio with regard to current conditions, especially by shifting its ratio of “aggressive” common stocks and “defensive” bonds; or the common stock fund, which maintains a largely fully invested position with a view toward selecting seasoned issues; or the bond fund, which maintains a portfolio solely of bonds. If the investor prefers to exercise a greater degree of management, he may choose the specialty fund, of which there are two types: the industry type, in which a share is backed by a diversified list of issues in an industry of the investor’s choice; and the objective type, in which the investor picks his objective and participates in a diversified list of stocks most likely to fulfill it. Thus, the mutual fund offers the investor a wide variety of shares from which to choose, to suit his objectives of either capital appreciation, capital preservation, or reasonable income, or varying combinations of each.

The advantages of management, diversification, income, liquidity, and inflation hedging which the funds provide will be discussed in separate sections. However, the investment companies perform several additional minor functions which may be mentioned here: their portfolio shares are held by a custodian—usually a bank—and are thus safe from damage or loss (but not depreciation in value, as the recent Securities and Exchange Commission Statement of Policy indicated2); the dividends are quarterly, not scattered and small, and the investor need not be concerned with proxies, warrants, and stock splits; and finally, there is convenience in income tax returns, with the investment company required to send a year-end statement of the taxability of dividends. This chapter will now proceed with an analysis of the degree of success the funds have attained in providing the more important advantages to the investor.

… the judicious selection of securities, based on extensive research and systematic plan, in order to accomplish the objectives of investment …

The individual investor in most cases has neither the time nor the knowledge to manage his own investment account. This lacking is made clear in the oft-quoted statement by the late Louis D. Brandeis, Associate Justice of the United States Supreme Court:3

…the number of securities on the market is very large. For the small investor to make an intelligent selection from these—indeed, to pass an intelligent judgment on a single one—is ordinarily impossible. He lacks the ability, the facilities, the training, and the time essential to a proper investigation. Unless his purchase is to be little better than a gamble, he needs the advice of an expert, who, combining special knowledge with judgment, has the facilities and incentive to make a thorough investigation.

The mutual fund supplies the investor with this expert management, at relatively low cost, with its objectives stated so that the investor can carefully determine which fund best suits his needs. Besides these advantages, the management usually has sufficient cash position to “average-down” in a period of market recession,4 and is therefore able to take advantage of prevailing low prices. The individual investor usually lacks the capital to do this.

Investment company management is usually steered by a Board of Directors or a Board of Trustees, composed largely of the company officers, established businessmen, directors of corporations, accountants, lawyers, bankers, and members of stock exchanges. The Boards do not suffer by comparison with the director lists of any large corporation, and include a Trustee of the Committee for Economic Development, the treasurer of American Telephone and Telegraph, an ex-governor of West Virginia, president of the Wilson Line, and an associate dean of the Graduate School of Business Administration of Harvard University.5 In accordance with the Investment Company Act of 1940, the Board of Directors may not be radically changed without stockholder consent; a majority of the directors may not be affiliated with investment bankers or the investment company’s regular brokers, and must be independent of the company’s sales-distribution organization; and 40% of the board may not be investment advisers or officers of the company.6 These provisions give positive protection against control of fund investment policy by sales groups, brokerage concerns, and investment banking houses.

The cost of management is usually stated as a percentage of net asset value per share, computed quarterly in most cases. It ranges from 1/2 of 1% to 1% of total assets, and is stated even as a daily figure (1/730 of 1% of average daily net assets) in order to give the investor the impression of an extremely low cost. Nevertheless, there is some indication that the cost of management is too high: first, the fees come to from 5% to 15% when computed as a percentage of income; and second, there are costs additional to the management fee, such as custodian and stock transfer fees, mailing and printing, clerical salaries, administrative and legal fees, and state and local taxes, which usually amount to from 20% to 50% of total expenses, the remainder being composed of the management fee. However, the careful investor can ascertain these percentages for himself by investigating the prospectus, and then make his investment on the basis of his findings.

Evaluation of Management Success
Investors must expect the value of their investment company shares to rise and fall with the market, although the average open-end fund is likely to dampen the amplitude of any market fluctuation. Management can scarcely be expected to buy so that the fund can stay ahead of the market when the very securities that it buys are a part of that market. However, the investment company should not saddle its investors with a greater loss than the fall in portfolio values. The closed-end companies did this in many cases after the 1929 crash, since their shares were purchased at a premium and sold at a discount during the depression. Open-end shares may not be bought or sold in this way, however, and their comparative superiority can be clearly seen in relative performances in the 1929–1936 period: in 193 closed-end management companies, the average per share asset value declined by 35.3%, while in 49 open-end funds, the value increased by 6.7%.7

Wellington Fund states its objectives as “ … to pay reasonable dividends, to secure profits without undue speculation, and to conserve principal.”8 Its record reveals a 3.8% dividend rate over the past sixteen years, during which it also made security profit distributions averaging 2.6% each year. The net asset value has fluctuated only slightly over one-half as much as the Dow Jones 30-stock Industrial Average in the last decade.9 Fund principal has been conserved quite remarkably, as revealed by the net asset value per share variation: the high was $24.58 in 1929 (the year the fund was organized) and the low was $11.50 in 1932. A share purchased at any year-end in the fund’s history would have a greater value at the present, except for purchases in 1929, 1936, and 1945, all of which were peak market years. Assuming all dividends were reinvested, the share value increased by 100% in the 1934-1949 period, compared with an 83% increase in the Standard & Poor 90-Stock Average.

…the distribution of investments among different issues of securities in order to decrease the risk on any one investment…

Closely connected with the concept of management of the investors’ funds is the idea of diversification, which is said to minimize the risk of any single commitment and contribute to the stability and continuity of income. Investors must realize, however, that with a decrease in the chance of a net loss by the spreading of risks, there is also a limitation on the effect of a windfall gain. This aspect or a limit to profit as well as to loss is naturally one rarely stressed by investment companies. Investors must also realize that diversification cannot protect against cyclical market declines. Diversification is tied to management by the fact that it must be informed and intelligent, not merely wide; it must be managed rather than random. Most funds do use sound judgment in diversifying their portfolios, and the criticism that the funds merely “buy the averages” is seen as invalid, since a survey by the writer of twenty funds indicated that each had an average of but eight of the thirty widely-known stocks comprising the Dow-Jones Industrial Average. The fallacy of merely wide diversification is clearly indicated by the stock market crash of 1929. Although closed-end leverage companies averaged 87 issues in their portfolios, and closed-end non-leverage companies averaged 60.2 issues, their capital decline was far more severe than that of the open-end companies, which averaged only 46.8 issues.10 The latter were virtually required to buy sound, seasoned, marketable issues, primarily because they had to be able to liquidate parts of their portfolios on demand for redemptions by shareholders.

A few examples of why the individual needs diversification may be made. First, he cannot properly invest in a single stock without risk, as shown by the following examples [in Figure 1] of “blue-chip” stocks which declined in value in 1949, a year when the averages rose about 10%.

Leading Issues Which Declined In Value In 1949

Even over longer periods, a single investment offers a very great risk. In the 1939–1949 period, when the Standard & Poor 90-Stock Average rose 110% (assuming all dividends reinvested), [the major] issues in [Figure 2] declined.

With the indication that selection of individual securities is at best an extremely risky proposition, it seems pertinent to indicate the requirements for diversification in the fund portfolio. First, the Investment Company Act requires that

    at least 75 percentum of the value of its total assets is represented by cash and cash items, government securities, securities of other investment companies, and other securities limited in respect of any one issuer to an amount not greater in value than 5 percentum of the value of the total assets of such management company and to not more than 10 percentum of the outstanding voting securities of such issuer.11


Issues Which Declined In The 1939-1949 Decade

Moreover, the investment company is not allowed to change its basic policy statement (i.e., from a diversified to a non-diversified company) without the consent of a majority of its stockholders.

In the second place, many funds impose upon themselves greater restrictions as to the amount and quality of diversification through restrictions in their charters. The following examples are typical:

  1. To hold no more than 10% of any company’s stock.
  2. To invest no more than 5% of assets in any company. (These two restrictions in effect make the government requirements effective for the entire portfolio.)
  3. To limit borrowing to 10% of assets.
  4. To limit underwriting to 5% of assets.
  5. To invest not more than 2% of assets in securities of an issuer that has been in operation for less than three years.
  6. Not to invest in securities of other investment trusts.
  7. Not to hold more than 5% of assets in securities not listed on the New York Stock Exchange or on the over-the-counter markets.

A few examples of diversification in various investment companies [in Figures 3 and 4] indicate how wide it is.

Naturally, the investor has to pay a price for diversification. In the open end company it is the load, or sales charge, on the purchase of each share.12 There has been much criticism of the large size of the load, which usually runs from 6% to 9% of the net asset value per share, depending on the fund. Although, strictly speaking, the load is the cost of distribution, since the fund itself never receives any part of it, it may be considered as the cost of diversification for two reasons: first, because the test of cost is the value (i.e., the portfolio shares) obtained for a price, and secondly, because the load is a commission paid in buying an investment company share, just as a brokerage commission must be paid in the purchase of shares of listed stock, of which the portfolio is composed. Although it is more favorable to compare the load with any dealer commission—since both are the costs of bringing the service to the consumer—it seems closer to reality to compare it with the costs incurred in actually duplicating the purchase of the investments in the portfolio which the investment company share represents.


Diversification By Industry In Selected Funds

Diversification By Issues In Selected Funds

The funds claim that, for the individual, commissions and other buying and selling costs in obtaining diversification would exceed the cost of the mutual fund shares. To buy but one share of each of the securities in the Dow-Jones 30-Stock average would cost $1,800.81. The commission charges on the purchase and the resale of each share would amount to 11.16% of this purchase price.13 This example indicates the importance of the “round-trip” feature of the sales load, which means essentially that the investor is paying both the buying and the selling commissions at the same time.

The load payment, as mentioned before, does not go to the fund itself. An eight dollar commission would be distributed in approximately the following fashion: $2.00 to the dealer, $3.50 to the salesman, and $2.50 to the sponsor, or principal underwriter, who pays for the sales literature and wholesaling. This peculiar situation, whereby the fund does not profit directly from the sale of its securities, means that a fall in the cost of a share (through a reduced load) will not lead to a rise in the amount of shares demanded: a lower load is likely to mean decreased sales, since it entails a lower profit for the salesman, who in turn can divert his effort to the sale of another fund, since there are a great variety of similar fund shares available. Merrill Griswold, chairman of Massachusetts Investors Trust’s Board of Trustees, presented the implications of a lowered load when he told the Securities and Exchange Commission, at the 1939 public examination of MIT:

If we had at that time (1932) reduced our sales load to 5 ¾ (it was then 8 ¼), I don’t think anybody would have sold any of our shares to anybody.14

All things taken into consideration, it would seem that the load is perhaps too high. Although it is justified in a purely economic sense since the public is willing to pay that price for shares, and in a social sense since it keeps the small investor from speculative “switching,” an eventual reduction in sales loads would doubtless increase the number of holders of investment company shares, at the same time increasing the distributors total revenue by the higher sales volume.

…the recurrent money payments proceeding from the disbursements of the institutions in which funds are invested…

With the fall in interest rates and bond yields the reasonable and regular dividends provided by investment companies are extremely important to the individual investor. So far as is known, no mutual fund with income as its objective has ever passed a dividend from investment income. Although there is no guarantee or continuous future return, it seems logical to assert that dividends will be forthcoming as long as American industry continues to make profits, since it is the return on the portfolio of the investment company which provides it with cash for its disbursements.

The increasing divergence of stock dividends and bond interest rates is probably a substantial reason for the growth of the investment company. The depression and the great capital losses to investors which resulted from it caused a greater desire for safety of principal, but gradually confidence in stocks (and especially in a diversified group of them) returned, and during the same period bond rates fell. The combination of high income and safe principal thus shifted in favor of the common stock element. In spite of the fact that many funds urge that part of the investor’s capital should be devoted to bonds, after he has cash reserves and insurance needs filled, it seems doubtful that this advice has been widely followed.

Proof of the relative regularity of investment company dividends can be seen from an analysis of three companies [in Figure 5]. Boston Fund, Fidelity Fund, and MIT averaged 4.3% in dividends from income over the past ten years, and never missed a quarterly dividend.

Investment Company Dividends From Income

There is a virtual legal requirement for the investment company to pay out its income in dividends, for to qualify (and thus gain tax exemptions) under the Internal Revenue Code, Supplement Q, the investment company must distribute as taxable dividends not less than 90% of its net income, exclusive of capital gains, for any taxable year. If it complies with this requirement, it pays no tax on the amount so distributed. This supplement prevents what would otherwise be triple taxation, with the government receiving a tax on corporate earnings, on the dividends from those earnings distributed to investment companies, and on the amount mutual fund stockholders get from their dividends.

Capital gains distributions present a problem to the investor as well as to the investment company. They are derived from net profits realized from securities transactions, and generally occur in periods of rising stock prices. For this reason, most companies encourage their reinvestment, and thus hope to prevent this reduction of working assets. The encouragement usually consists in the elimination of the loading charge when dividends are reinvested. Examples of this policy are evident in the Keystone prospectus, which says that capital gains distributions “…may be reinvested in additional shares of the fund at net asset value at the time of reinvestment,” which must be within thirty days after the date of payment.15 MIT says in its 1950 prospectus that they should “ …be regarded by the shareholders as distributions of principal and not as income …”16 and that “ …shareholders will be offered the opportunity to reinvest the cash so distributed in shares of the trust at net asset value.”17

The instability of capital gains dividends can be seen by a survey [in Figure 6] of the three companies whose dividends from income were shown as quite regular.

Investment Company Capital Gains Disbursements

This instability has been in many cases disregarded by the funds in their sales literature, in which dividends were often quoted as the total of securities profit distributions and income distributions, thereby showing an abnormally high rate of return. It is clear that in a declining market, the capital gains portion would certainly decrease if not disappear entirely, so the practice seems misleading to the investor. The SEC Statement of Policy of August 11, 1950 took account of this when it declared that it is “ …misleading…to combine into any one amount distributions from net investment income and distributions from any other source.”18

One advantage of capital gains dividends that has been exploited in a few cases by specialty funds has been the fact that the investor need only pay capital gains taxes on security profit distributions, thus cutting his tax roughly fifty percent. Growth and speculative funds have therefore been made available to the investor whose taxable position is such that capital gains are more valuable than regular dividend income.

…the quality of being convertible into cash at a price approximating the value of the investment…

Liquidity of shares, or their redeemability by the fund at approximately net asset value, serves a dual advantage for the investor.19 First, it makes it possible for him to receive the fair value of his share on demand, and second—a corollary of this advantage—the management must be sensitive to his desires and is thus responsible directly to him. Although redeemability is the unique feature of the open-end company, the Investment Company Act of 1940 made it statutory, giving the investor the privilege of redeeming shares at a price approximating net asset value within seven days, except when the New York Stock Exchange is closed under extraordinary conditions or SEC declares an emergency to exist, during which it is impracticable either for the investment company to dispose of its securities or for it to fairly determine the net value of its assets.20

The redemption feature establishes a continual market for the fund shares. Incidentally, there was no interference with the redeemability right in the market breaks of 1929, 1937, and 1946; and the New York Stock Exchange has been closed only once in the twenty-five years that the mutuals have been in business. In practice, there has never been any appreciable waiting period between the time shares are tendered for redemption and the fund’s payment of cash to the shareholder.

There are two factors which can relieve the company of the necessity of liquidating its portfolio securities to meet a run on redemptions, both of which are provided for in the Investment Company Act. First, section 18(f) allows bank borrowing “ …provided that…there is an asset coverage of at least 300 percentum”; thus the funds may borrow to meet current (and temporary) negative net sales. Second, the issuer is allowed, under section 2(a)(31), to compensate the holder with “approximately his proportionate share of the issuer’s current net assets,” rather than “ …the cash equivalent thereof.” This provision has not been used, however, and some funds limit their redemption payments to cash value alone.

In practice, redemptions have proved to be a relatively fixed percentage of total assets, so with greater size, the investment company must increase its sales in order to gain the same amount of net sales [see Figure 7]. During economic crises, sales and distribution efforts have to be increased in order to offset high redemptions by the jittery public. These increased efforts were clearly shown in the 1927–1936 period, when only in two quarters did redemptions exceed sales.

Relationship Of Fund Redemptions To Total Fund Assets

Besides the advantages of redeemability per se to the investor, the concept has three very important implications; first, a major portion of the portfolio must be composed of highly seasoned securities of ascertainable market value; the holding of this type of security, the writer submits, is one of the reasons the open-end fund survived the depression so much better than its closed-end counterpart. Second, the redeemability feature prevents the use of senior securities, since redemptions could destroy the equity behind such securities. The investor, therefore, is never in danger of having his interests subordinated by the use of preferential capital.21 Third, the threat of withdrawal means that management must continually provide satisfactory performance, at the risk of having to liquidate its portfolio and go out of business.

Hedge Against Inflation
…to safeguard the purchasing power of capital by investing it in things which advance, in both price and yield, as the cost-of-living advances…

It seems a basic economic truth that the most likely investment to appreciate in value and in return as the purchasing power of the dollar falls is an investment in common stocks. Although the correlation between stock value and price level is by no means perfect, common stocks offer the investor far greater purchasing power protection than do bonds or savings accounts. It is logical to assume, therefore, that the investment companies, varying with the market and having portfolios composed largely of common stocks, will also provide the investor with a “hedge” against the rising prices of consumer goods.

Professor Sumner Slichter, professor of economics at Harvard University, has said that an investment counsel who advises his client to place his funds in savings banks, postal savings, or government securities “is assuming a very heavy responsibility,” asserting that properly selected stocks should prove to be a reasonable protection against the rising cost of living.22 In his opinion, unless the government issues savings bonds payable in a fixed amount of purchasing power rather than in fixed dollar amounts, the well-managed mutual fund is the best answer to the problem of inflation for the small investor.

Certainly the mutual fund offers a better hedge against purchasing power decline than would bank deposits or bonds, which are taxed in dollar rates. The value of common stocks, in a survey by Emerson W. Axe, was shown to yield an average of $2.80 for each dollar invested during twenty-year periods from 1858 to 1948, under a plan of dollar-cost-averaging which required the investment of $1,000 each quarter in a common stock average.23 This procedure enables the investor to spread his investment over time. In the worst period (1918–1938), the amount realized was $164,181 on an initial investment of $80,951 (plus reinvested dividends of $56,112). The best was 1908-1928, after which $347,474 was realized from an initial investment of $81,015 and reinvested dividends of $87,896. These amounts are comparable with $99,594, the realized amount from $4,000 invested annually for twenty years in a savings bank, at current rates.

Some funds specifically attempt to procure common stocks which will provide a hedge against inflation. Bullock’s Dividend Shares, for example, claims that 67.6% of the shares in its portfolio provide this characteristic in an exceptional degree.24 Inflation hedge stocks are

    namely, the common stocks of those companies producing basic raw materials, as well as others which can be expected to experience an increase in dollar income sufficient to offset the decline in the purchasing power of the dollar.25

They include all stocks whose 1940–1950 net earnings per share have increased in an amount exceeding the rise in the cost of living.

On the basis of limited information, then, it appears valid to assert that both income from and principal of an investment company share will tend to keep pace with the cost of living; at any rate it will do so better than fixed-income investments. It must be noted, moreover, that the last thirty-five years have been years of extremely unstable price levels, as a result particularly of price control during the first and second World Wars, and extremely unstable securities, particularly in the decade surrounding the 1929 crash.

Fund Sales Policies
With these advantages for the small investor, the fund has left the traditional marketing area for securities to tap wealth in other parts of the country. The North Atlantic seaboard, which supplies some 69% of the volume of trading on the New York Stock Exchange, bought but 31% of the one billion dollars worth of fund shares sold in the 1946-1948 period.26 A study made by the National Association of Securities Dealers showed only three states with less than 1,000 mutual fund shareholders—Delaware, Nevada, and Wyoming—the top seven states being California, New York, Missouri, Michigan, Massachusetts, Illinois, and Pennsylvania. However, the states with the highest ratio of fund investors to total population were New Hampshire and Maine, with New York ranking twenty-sixth and Pennsylvania thirty-second. Besides going to largely new geographic areas, the funds are taking advantage of the new distribution of the national income in the United States [see Figure 8]: only 32% of the population now earn less than $3,000 each year, compared with 85% in 1937; 51% earn from $3,000 to $7,500, compared to 7% in 1937.27 The distribution of the income has gravitated considerably toward the hypothetical “line of equal distribution”, with the highest percentiles having moved one-half the way to perfect equality since 1937. In addition to this new distribution of wealth, there is a new total wealth in the economy: since 1937, savings have increased by $20 billion, disposable income by $120 billion, and liquid assets in individual hands by $107 billion.28 The investment companies are trying to reach this new wealth. There are three general ways in which the attempt is being made: sales and distribution policies, periodic payment plans, and advertising.

Changes In National Income, 1937 And 1948

In addition to the sales forces of the distributors of mutual funds, there are some 4,000 over-the-counter dealers who handle mutuals. Estimates of sales forces are unavailable, but a very high average might be indicated in the case of Investors Diversified Services, which is said to have 1,700 salesmen in the United States and Canada. The number of investment houses which handle investment company shares has increased, during the last ten years, from only a handful to over 500, possibly to take advantage of the small dollar-unit transactions through mutual fund shares. The funds can bring new investors to Wall Street more easily than the New York Stock Exchange can, since commissions there are too low to permit high advertising, canvassing, and distribution expenses. Wall Street ought to be grateful to the funds for their merchandising, since “investment companies are the best customers for common stocks that the market has today.”29 Certainly one reason for the success of the sales and distribution expansion of the investment companies are the advantages it gives to the dealer and salesman, the former of whom likes the high commission, the constant supply of shares, and the fact that he does not need to tie-up any capital; and the latter of whom appreciates the publicly-announced price of the shares, the generous commission, and the variety of literature and fund facts available.

With regard to advertising, the funds (and their distributors) have incurred large expense by the publication of elaborate brochures and sales literature. This expense is paid for, in effect, by the shareholders, through the medium of the sales load. Examples of the type of literature—generally more promotional than informative—can be seen from the titles of several pamphlets. “A Personal Investment Account for the Professional Man,” “A Plan for Tomorrow for the Woman of Today,” “Dollars at Work in American Industry,” “The Investor’s Hour of Decision,” and “What can a Mutual Investment Fund do for me?” All mediums—radio, television, newspaper—are used for advertising, with the importance of the latter having been increased in recent years due to a more liberal interpretation by the SEC of the Securities Act of 1933, which in part restricted the advertising of new issues of securities (under which investment companies are classified because of their unlimited capitalization) to “tombstone” advertisements. However, by the summer of 1950, the advertising became too zealous and in many cases too misleading, so on August 11, 1950, the SEC issued a Statement of Policy, written with the cooperation of the NASD and several fund executives. Its restrictions indicate where many of the malfeasances of the investment company advertising lie, so some of its major provisions will be listed below. The Statement of Policy makes it “materially misleading” for sales literature:

  1. to imply assurance of stable, continuous, dependable, or liberal return.
  2. to imply preservation of capital without indicating the market risks inherent in investment.
  3. to refer to government regulation without stating that it does not involve supervision of management investment policies
  4. to imply redemption value will exceed cost.
  5. to imply shares are generally selected by fiduciaries.
  6. to compare performance with market averages without indicating that the period was selected.
  7. to make extravagant claims with respect to management competency.

It is clear that the correction of advertising abuses will in the long run be beneficial to the industry as a whole, since investors that are misled, even unintentionally, will certainly not be satisfied “consumers” and buy more fund shares.

Insofar as providing advantages to the individual investor, then, the investment company has fulfilled its economic role. The soundness of management, the careful diversification, the liberal income, the share liquidity, and the hedge against inflation all combine to make the investment company share the most proper investment for the middle-income investor.


Thesis Conclusion
“As...the principles of diversification on which these (investment) companies operate is a sound one, the only probable causes for loss of public confidence would be gross mismanagement or, more likely…, misunderstanding on the part of the public as to the nature of equity investment as such, and consequent expectation of miracles from investment company management.”30

The tremendous growth potentiality of the investment company, in conclusion, rests on its ability to serve the needs of both individual and institutional investors. It can do this best by stating its objectives explicitly, so that a minimum of investor misconception as to the fundamentals of equity will exist. The investment company industry must prepare for its next hurdle, which is likely to come from a serious decline in the securities market, by making it clear that its shares are not panaceas for all the ills of investment. That the market will fluctuate is certain, and merely because it has experienced a general upward trend in the decade of the investment company’s greatest growth may have made many investors fail to realize that the share value, like the market, is liable to decline.

To further serve the interests of investors, and thereby increase its own size, the investment company may institute new types of shares in the future. There is need for a venture capital fund, as well as funds composed of tax-exempt securities, funds with the securities of industries in given geographic areas, and special investment companies to serve the specific needs of pension and trust funds by placing a higher percentage of government and corporate bonds in the portfolio. Aside from serving investors by increasing the breadth of its activities, the investment company must continue to serve them as it has in the past, with management operating in the most efficient, honest, and economical way possible. By this high-grade operation, the investment companies in the future can sell their shares to the non-investors of the present, thereby increasing the percentage of securities holders above the 8% of the population which hold them today. The investment company has grown up to now by concentrating its sales power on the prospering stratum of the economy; perhaps its future growth can be maximized by concentration on a reduction of sales loads and management fees.

The fact that the investment company may serve economic roles other than providing advantages to the investor should in no way be construed to imply that that is not the function around which all others are satellite. It seems clear that through investment in equity capital, through influence on corporate management, and through stabilizing the securities exchanges, the mutual funds are serving to the fullest advantage of their shareholders. If other roles arise in the future, they must be cautiously analyzed, and discarded if they interfere in any way with the interests of the investors.

As it was stated in the Harvard Law Review:

It is important to bear in mind that the principal function of investment the management of their investment portfolios. Everything else is incidental to the performance of this function.31

Mutual funds, then, are not designed to replace bonds, the banks, and insurance companies, but rather to supplement their stability with a more adequate income. The investment company can realize its optimum economic role by the exercise of its dual function: to contribute to the growth of the economy, and to enable individual as well as institutional investors to have a share in this growth.


  1. Author’s computation from figures given by the National Association of Investment Companies.
  2. [See p. 20].
  3. Quoted in “Trusts and Estates,” LXXXVIII (August, 1949), p. 495.
  4. That is, has sufficient cash in order to buy shares at the low market prices and therefore lower the average price of the shares in the portfolio.
  5. The directors of today are presumably more cautious than was Charles F. Kettering, vice president of General Motors Corp., who invested $260,000 during the late ’twenties in an investment trust of which he was a director, and subsequently realized but $20,000.
  6. Respectively, sections 16(a), 10(b), and 10(a).
  7. Securities and Exchange Commission, “Investment Trusts and Investment Companies” (Part 2), p. 508.
  8. Wellington Fund, Prospectus (April 14, 1950), p. 2. Other figures from their sales literature.
  9. Wiesenberger, Arthur, op. cit., p. 113. All future “fluctuation” figures also from this source.
  10. Securities and Exchange Commission, op. cit., p. 546.
  11. Section 5(b) (1).
  12. There is ordinarily no charge in redeeming the share.
  13. Wellington Fund sales brochure, Cost vs. Value, p. 3.
  14. SEC, op. cit. (Part 3), p. 811.
  15. General Prospectus, February 10, 1950, p. 7.
  16. Prospectus, February 24, 1950, p. 4.
  17. Ibid., p. 8.
  18. SEC, Statement of Policy, p. 2.
  19. In many cases the fund authorizes the principal underwriter to act as agent in the repurchase of shares.
  20. Section 22(e).
  21. Section 18(f) of the Investment Company Act makes it illegal for open-end investment companies to issue senior securities, thus incorporating this provision into law.
  22. Quoted by Long, Henry A., “Mutual Funds Mature,” Trusts and Estates, LXXXIX (September, 1950), p. 606.
  23. Axe, Emerson W., “The Record of Equity Investment,” Trusts and Estates, LXXXIX (August, 1950), p. 508.
  24. Dividend Shares, “Today’s Tests for Common Stock Investment,” p. 1.
  25. Ibid., p. 1
  26. National Association of Securities Dealers figures quoted by Dorsey Richardson, “Speech to Investment Bankers’ Association,” December 6, 1949 (mimeo.), p. 4.
  27. Investment Companies Committee, “Report to Investment Bankers Association of America” (1949), p. 1. (mimeo).
  28. [Ibid., p. 1.]
  29. Mindell, Joseph, “Wall Street Doesn’t Sell Stocks”, Fortune, XL (April, 1949), p. 79.
  30. Richardson, Dorsey, Address before National Association of Securities Administrators, October 9, 1950, p. 6.
  31. Motley, Warren, et al, “Federal Regulation of Investment Companies since 1940,” Harvard Law Review, LXIII (July, 1950), p. 1142.


Securities and Exchange Commission, “Investment Trusts and Investment Companies,” Washington: Government Printing Office; Part 1: p. 158 (1939); Part 2: p. 937 (1940);

Part 3: p. 2804 (1941); Parts 4 & 5: p. 384 (1942)

Wiesenberger, Arthur, “Investment Companies—1950” (New York: Arthur Wiesenberger & Co., 1950), p. 336.


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