Investment Companies

Put not your trust in money, but put your money in trust.      —OLIVER WENDELL HOLMES

INTRODUCTION

An investment company is a cooperative agency, having as its purpose the investment of the con­tributed funds of its members in a diversified portfolio of securities, the administration of which rests entirely with the management. In this manner the investor is able to participate in diversified investment without being under the necessity of making any selections himself and also is able to obtain the managerial supervision which he himself could not provide. Investment companies have been known by various titles, such as investment trusts, mutual funds, etc.; their origins in the United States are relatively recent, many having been founded prior to the depression of the thirties. In 1940 the Invest­ment Company Act became a law, providing for strict regulation in order to protect the investors themselves; included are matters such as the out­lining of basic investment policies, the publica­tion of semiannual reports, regulation of sales practices, the minimum capital requirements, nature of debt, qualifications of directors, etc. It is considered by many that the passage and en­actment of the Act ushered in an entirely new era for the investment companies because of the disappearance of certain questionable practices of the past.

It must be quite obvious that the objectives of a given investment company may be very differ­ent from those of another; indeed, the objectives are as varied as those of individual investors. Some companies are exceedingly conservative and confine their purchases to good-grade bonds and/or preferred stocks; some, at the opposite extreme, deal exclusively in common stocks; still others, commonly known as "balanced funds," invest in both bonds and stocks, the proportion being varied in order to meet certain consid­erations dictated by the existing economy. Evi­dently, the degree of risk may also be quite var­ied, since it is well understood that investment in good bonds is conservative, while investment in common stocks may involve a certain amount of speculative risk. The degree of risk entailed by investment in a particular company will largely depend upon its own investment objec­tives, which must be definitely stated under the Act of 1940, and these may not be changed with­out stockholder approval; consequently, the pro­spective investor has some previous knowledge of the nature and aims of the company in which he proposes to invest; the company literature (known as the "prospectus") will set this down in no uncertain terms. In some cases, the very ti­tle itself may indicate the nature of the com­pany, such as "The Ultraconservative Bond Fund," the "Galloping Growth Fund," the "PDQ Petroleum Stock Fund," etc. However, this represents only one side of the coin. The other is the long-range investment policy, which may take the form of continued income, capital gains, growth within an industry, etc. It is easily seen that the investor will have a very wide va­riety of investment companies from which he may make a choice, both as to the nature of the company's portfolio and the long-range objec­tives as well.

Investment companies are usually corpora­tions, although a few are Massachusetts trusts. All final decisions regarding policy, purchase and sale o£ portfolio securities, research, declara­tion of dividends, etc., rest with the directors or trustees, as the case may be. Sometimes the ad­vice and research portion may be handled by an investment counsel firm under contract, by which all such advice and research are furnished for a stated fee. Even management may be han­dled on a contract basis, since there are firms which make a business of doing this work. It may be remarked that the use of subcontracting is a means of reducing expenses and this is now quite common practice.

Much may be said as to the classification of in­vestment companies. For our purposes it will be sufficient first to set forth the characteristics of two broad types, afterward showing the sub­headings within each. These two are the closed-end company and the open-end company.

THE CLOSED-END COMPANY

The closed-end company is one that has a spe­cific amount of capital and whose securities re­semble those of any other business corporation (bonds, preferred and common stocks); its busi­ness is rather unusual since it deals exclusively in the securities of other corporations for income and for profit. The shares of closed-end compa­nies are usually common stocks, bought and sold through the stock exchanges or the over-the-counter market. Stockholders in a closed-end company are able to sell their shares for what they will bring at any time, just as the shares of other corporations are traded daily. Examples: Carriers and General, National Aviation, Petro­leum Corporation of America, Tri-Continental, United Corporation, Adams Express, Lehman Corporation. The term "closed-end company" refers to the limitation placed upon the number of shares issued, which may then be bought and sold only from the existing stockholders. In con­trast, the open-end fund both sells and repur­chases its own shares.

From the investor's point of view, the most in­teresting thing about closed-end shares is the manner by which they are priced. Being traded on an established market, such as the New York Stock Exchange, the shares are priced entirely upon a supply and demand basis, as is the case with the shares of any ordinary business corporation. As a result, the shares of many closed-end companies are often available at a discount from their net asset value, so that dividends may be­come quite attractive and opportunities for prof­its often present themselves.

While the capitalization of a closed-end com­pany is relatively simple, such as common stock alone, the price at the market place will usually reflect the supply and demand for the particular stock; but where the capital structure is more complicated, as in the case where both bonds and common stock are outstanding, another fac­tor enters into the price. This is called "leverage" and has been discussed in a previous chapter, which indicated that it may afford a rather large prospective gain in good times, especially with a rising market, but also may wipe out all gains in poor times and a falling market. The extent of leverage in any case will depend upon the capi­tal structure, but the lesson is quite clear: avoid leverage shares! They do not represent invest­ment, but speculation—and the investor of lim­ited means, as we have so often remarked before, cannot afford to speculate.

THE OPEN-END COMPANY

The open-end company is one which issues and sells its shares and which stands ready to re­deem them at any time at a price which approxi­mates the new asset value. Since shares are being continually bought and sold, the open-end com­panies appraise their shares twice daily. As it re­quires some sort of sales organization or distribu­tor to sell the shares, it is easily seen that the selling price must include this expense in some form as a charge over and above the net asset value; this amounts to approximately 6 to 9 per cent and is commonly called the "loading charge," although there are a very few funds which do not make such a charge.

Many heated arguments are fostered by the use of this "loading charge" and some invest­ment counselors maintain that this "eats up" the earnings for the first few years and that the in­vestor receives nothing as an immediate return from his investment; they add that ordinary listed stocks of good quality may be bought at a much lower cost and will yield some immediate return. There is much truth in such an assertion, but the mutual-fund boosters point out that the surcharge is really a payment for management, which latter is the very reason why the investor is purchasing the open-end shares in the first place.

Open-end funds may well be classified accord­ing to type, since each attempts to achieve a cer­tain objective:

The bond fund, as the name indicates, invests its funds entirely in a portfolio of bonds, usually of good grade; such a fund is characterized as be­ing quite conservative since safety of principal is the main objective, which entails a low rate of return. Examples: Keystone Custodian Bl (high grade) and B2 (medium grade), Bond Fund of Boston, Manhattan Bond Fund, Group Securi­ties General Bond Fund.

The balanced fund is one which maintains a goodly portion of its resources in bonds and/or preferred stocks and places the remainder in common stocks. The former commitments are defensive and conservative, and their proportion is usually varied within certain limits depending upon the judgment of the management. The balanced fund is considered by many as a good compromise between strong conservatism and rather considerable speculation. Examples: Ea­ton and Howard Balanced; Scudder, Stevens and Clark Balanced; Boston Fund; Wellington Fund.

The diversified common stock fund comprises the largest group in total membership. All invest in common stocks, but there is a wide degree of difference in the approach. Some specialize in "blue chips," some specialize in growth stocks, some confine themselves to low-priced shares, some stress certain industries, such as chemicals or petroleum; still others may stress a certain business segment and the possibilities of growth within it (e.g., electronics). Examples: Axe-Houghton Stock Fund, Broad Street Investing Corp., Commonwealth Stock Fund, Loomis-Sayles Mutual Fund, Science and Nuclear Fund.

We may note that the chief purpose of many funds is income; for others, capital appreciation; and for still others a bit of both.

TAXATION

Taxation of the profits of investment compa­nies is of a special nature. Internal revenue law is so written that those companies which are willing to register as "regulated" investment companies and which agree to distribute at least 90 per cent of their received dividends and interest will be entitled to exemption from taxa­tion on such income and any capital gains paid out to shareholders; however, any other retained income must be taxed at ordinary corporation rates. The company must report to its sharehold­ers the nature of payments to them (interest and/or capital gains) and these will be taxed when received by the investor according to his particular tax bracket.

That the performance of the investment companies would be subjected to various de­grees of criticism is not difficult to understand. Such a diversity of funds, each trying to achieve certain objectives and not all being uniformly successful may mean that the failures undoubt­edly become magnified without taking into con­sideration the degree of risk involved. Invest­ment companies will involve a degree of risk which is commensurate with the type of portfo­lio they set up and the relative success or failure of the management to achieve their stated objec­tives; this is not much different from an individ­ual's successes or failures. The main differences seem to be that the purchaser of the investment company shares seems to feel that he is buying management services and that, therefore, such a management cannot make a mistake! Unfortu­nately, we are all human and mistakes may even be made by a board of directors as well as an in­dividual.

Another strong criticism which is frequently heard is that the performance of a fund is no bet­ter than an individual investor's would be if he is well informed and his sense of timing is good. Comparison of fund performance with various stock indexes, such as the Standard & Poor, have been made and have shown striking results in the case of some funds and rather mediocre per­formances for others. Investigations have also been made in order to appraise the manage­ment, since this is the most important matter re­quiring some sort of yardstick. The main point, however, is usually overlooked: the fact is that the neophyte investor is not so well informed as he should be, nor has he relatively large funds at his disposal; consequently, his participation in one of the investment companies may well be justified; and if the management produces re­sults, he will be well paid for the initial loading charge.

For the investor himself, there is some sort of moral in all this. One does not rush blindly into the purchase of investment-company shares any more than a prudent man would rush to buy the stock of newly formed XYZ Electronics Com­pany. Intelligent decision depends first upon what the investor wants for himself: income, capital gains, conservatism of principal, or even a bit of each; having decided what his ultimate aim may be, the next step is the selection of an appropriate fund—and here he may be quite be­wildered, for there are so many. In order to make a satisfactory choice, he should study the prospectuses of a number of them, paying par­ticular attention to those funds which have had a better-than-average performance over at least a decade. It is true that the purchase of investment company shares is a "way out" for the unin­formed, or for the investor who lacks the time and skill necessary to keep up with financial mat­ters; but there is one decision he should make and in which he should be so objective that no salesman can talk him out of it: which fund he should buy. The salesman of shares will attempt to show that the impressive rise in asset values is nothing short of phenomenal, forgetting that many private portfolios show similar gains; but the acid test is found in the results in the form of continued dividends and capital gains, which re­flect the degree of success which the manage­ment has achieved.

There seems no doubt that the well-managed investment company is becoming more and more a suitable vehicle for the savings of persons of modest means; no supervision is required of the individual, although he must use great care to read the semiannual reports with a criti­cal eye.

Open-end shares provide a safeguard in the standing redemption offer, but closed-end shares may often be bought at a substantial discount from net asset value; and the brokerage upon the latter is considerably less than the surcharge levied upon the purchase of the former.

Perhaps the most comprehensive publication dealing with investment companies is that is­sued annually by the Arthur Wiesenberger Com­pany of New York. Should the investor feel its cost to be beyond his means, he may consult it at many libraries and brokerage houses. Other crit­ical discussions may be found in the various com­prehensive and detailed textbook discussions of this phase of investment as a whole. Still others are to be found in certain issues of both Barron's and Forbes magazines, devoted especially to the subject of investment funds and their recent be­havior.

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