By: Frank Armstrong
By: Frank Armstrong, CFP, AIF
Three Boston securities executives announced their new investment vehicle in 1924: the mutual fund. The new offering, Massachusetts Investors Trust (now MFS Massachusetts Investors MITTX), would combine two tested investment concepts–the diversification of assets and professional money management–with two revolutionary ideas–continuous offering and redemption of shares and full disclosure of holdings and operations.
The concept took a while to catch on. The few comments that appeared in the press at the time said that the idea was fatally flawed and doomed to disappear quickly. By the Crash of 1929, there were hundreds of closed-end funds, with assets totaling $7 billion, but only 19 mutual funds, with a total of less than $200 million under management.
A Little History
Mutual funds didn’t materialize out of thin air. A number of developments led up to them.
From early Colonial times, qualified money managers handled the affairs of newly rich and prosperous capitalists, just as mutual-fund managers later handled investing for the not so rich and prosperous. In fact, fiduciaries even tended to the property and looked after the families of clipper-ship captains, traders, and owners during their long and dangerous travels on the China Sea.
In 1830, when famed Justice Samuel Putnam issued the Prudent Man Rule, the courts defined more broadly the duties a trustee has in carrying out his responsibilities. This ruling freed trustees from fear of personal liability so long as they acted prudently. The rule spurred the development of professional trustees, trust companies, and investment companies such as mutual funds.
In addition, pooled investment funds had operated in Europe as early as 1822 and in England from 1868. In the United States, the first pooled fund was set up in 1893, for the faculty and staff of Harvard University.
But what separated Massachusetts Investors Trust from previous endeavors (and caused the predictions of its early demise) was the unique offer to redeem shares directly from the fund. Earlier investment trusts issued a fixed number of shares, and these shares were traded based on supply and demand. The mutual fund, in contrast, continuously sold shares directly to the public and redeemed them upon demand at their present value.
Massachusetts Investors Trust also provided an unheard-of level of disclosure and transparency to investors. The fund issued detailed quarterly reports that included each and every one of its holdings, its transactions, and its costs. Before that, investment trusts operated in secrecy, believing that such details were none of investors’ business.
A Struggle for Acceptance
In retrospect, Massachusetts Investors Trust was launched during a particularly challenging time. Several unanticipated hurdles had to be cleared before success could be assured.
The fund’s ultraconservative investment policies were considered behind the times during the speculative fever leading up to the unfortunate events of 1929.
During the Depression, interest in stocks waned as stock prices fell as much as 80% from high to low. (The fund weathered the storm better than other investment companies, however, thanks to its conservative investment policies.)
The Roosevelt administration threatened to tax mutual-fund shares at the trust level. Such triple taxation would have been the death knell for the industry. President Roosevelt capitulated by including a “conduit taxation” provision in the 1936 Revenue Act.
A congressional committee investigating the causes of the crash and the Depression sought Draconian reforms for investment companies. Fund companies conceded that regulation was necessary and volunteered to write it themselves, resulting in the Investment Company Act of 1940.
Diverging Paths: Load versus No Load
Massachusetts Investors Trust and all subsequent products of Massachusetts Financial Services (today known as MFS) were available only through professional securities salesmen rather than directly to the public. In other words, they were load funds and remain load funds today.
Across town, another mutual-fund company took a different tack. In 1928, Scudder, Stevens and Clark (now known as Scudder Funds) had been wrestling with the problem of defining a new management function of “investment counsel.” These advisors would be free from the conflicts of interest that were an integral part of commissioned sales and underwriting. As one of their services for smaller accounts, they decided to offer a mutual fund without a sales load. No one thought much of the prospects for either the firm or the no-load fund concept. But over time, no-load funds have firmly established themselves in investor’s hearts.
Today, the open-end mutual fund is the investment of choice for American investors, offering instant diversification, low costs, low minimum investments, transparency, daily pricing, audited financials and operations, liberal shareholder services, stringent government regulation, and diversity of investment objectives and styles. There is hardly a market in the world that cannot be accessed through funds. No wonder funds are the basic building block for properly constructed portfolios.
In my next article, I’ll discuss a little-known theory that solves the problem of adjusting portfolios for investors with different risk tolerances and liquidity needs. It’s called the separation theorem, and it was pioneered by James Tobin in 1958. Watch for it on Thursday, March 9.