In 1940 fewer than 300,000 Americans owned open-end investment company shares. By 1966 more than 3.5 million Americans did. In 1940 mutual fund assets were valued at about $450 million. In the next 26 years they grew about 85 times to $38.2 billion. In perspective, the value of stocks and bonds on all registered exchanges increased only about 13 times (9.7 billion to 127.9 billion) from 1940 to 1966. During these years the mutual fund industry had been largely scandal-free and remarkably successful. Perhaps too successful. Regulators worried about what a mass exit from mutual funds could do to the larger market. This specter of “net redemption” was never far from the minds of regulators active during the 1950s and 1960s.14
This was not a new concern. Back in 1940, when mutual funds had a market value of less than one percent of the total value of all stocks on U.S. exchanges, net redemption concerns had spurred the SEC to attempt to put a cap on the size of mutual funds. After contentious congressional debates the industry ultimately turned this back, but in section 14(b) of the 1940 Act, Congress did authorize the Commission to monitor the consequences of market size. From 1952 through 1957 the value of the mutual fund market tripled. During 1958 alone it rose from $8.7 billion to $13.2 billion with 93 percent of mutual funds invested in corporate securities. Then the Commission decided to act, appointing four professors from the Wharton School of Finance and Commerce, led by Irwin Friend, to conduct the study authorized by section 14(b). Its chief concern, as the SEC put it later, was “the question of the effects of size on investment policies,” and particularly the “effects of increases in the size of investment companies on the securities markets.”15
The Wharton Study made use of surveys and questionnaires and gained industry cooperation through the National Association of Investment Companies, the trade association founded after the 1940 Act effort renamed the Investment Company Institute (ICI) in 1961. As the professors worked, mutual funds boomed. So in 1961, when Congress directed the SEC to report on these funds, the Wharton Study gained an external audience and heightened importance. Submitted in 1962, the Wharton Study found no problem with the size of mutual funds per se. It offered some evidence that net purchases substantially affected daily movement of the stock market and that mutual funds tended to trade with, rather than against the market, thereby destabilizing it. In the end, however, the authors acknowledged that questions about ability to stabilize or destabilize the market were “almost impossible to answer objectively.”16 But another, more concrete criticism touched off long-term contention between the funds and the SEC.
It started with the unusual structure of the industry. What seemed to casual investors like one company was in nearly all cases two: the fund management firm (staffed by registered investment advisers) and the fund itself, overseen by trustees. The problem was that investors tended to form a close relationship with the management firm and none at all with their actual counterparty, the mutual fund. The result was a conflict of interest and ample opportunities for collusion between the trustees and the managers.
The Wharton study found evidence of this in management fees, levied periodically against funds, which made no allowance for scale economies. In the early 1960s fund managers were charging from ½ to 1 percent of average annual net asset value, regardless of the size of assets, and as in other areas of finance, 500 shares were often as easy to manage as five. By 1962 this policy had resulted in some 50 lawsuits. Mutual fund management and advisory fees were double those in other financial sectors. Another structural problem fostering conflict of interest was the fact that the 1940 Act’s rule requiring a majority of independent board members was interpreted very liberally—it was acceptable for friends and business associates of fund managers to serve as trustees of the funds they managed.
The Wharton Study made no firm recommendations, but it did shed new light on the question of structural conflict of interest within mutual fund governance. More immediately damaging, however, was its charge that mutual funds were simply ineffective. The Wharton professors compared the performance of mutual funds with that of the 500 stocks in the Standard & Poor’s index and found that the performance of mutual funds “did not differ appreciably from what would have been an unmanaged portfolio”17 The industry countered that the average investor could never buy all of those shares, but the point remained, just what were investors getting for those fees? One answer was that they were getting people to assume their shares should they decide to cash out—85 percent of funds charged existing customers to pay for sales of new shares.
Given their guarantee to redeem the shares of existing investors at net asset value, continued sales was imperative for mutual funds. Not surprisingly then, most questionable mutual fund practices revolved around sales. As SEC staffer Harry Heller put it in 1957, “the present problems are largely in the open-end securities and largely in the selling method of open-end securities.”18 It was also not surprising that funds did not wait for new investors to call them up—they created incentives for brokers to aggressively go after new investors, giving rise to the axiom, common by the 1960s, that “mutual fund shares are sold, not bought.”19
If in the 1950s fund managers had put a premium on salesmanship, by the 1960s a few organizations had put it at the very core of their enterprise. These were the “integrated” companies that created their own funds and fielded their own sales forces. At the end of 1961, the two largest integrated companies, Hamilton Management and Investors Diversified Services (IDS), employed some 11,000 salesmen, few of them financial service veterans and none of them subject to regulation by the National Association of Securities Dealers (NASD). Merrill Lynch, the largest broker selling mutual funds, employed only about 2,200 salesmen.
The 1962 stock market break again raised the specter of net redemption and brought new scrutiny to the mutual fund industry. Part of the SEC’s wide-ranging Special Study of the Securities Markets focused on the problem of sales excesses. The Special Study documented in great detail high pressure techniques like “prospecting” and scripted sales routines. It also identified problems more distinctive to the mutual fund industry, particularly the devastating effects of the front-end load and the curious allocations of brokerage commissions.
Understanding that mutual funds had to sell shares to survive, the framers of the 1940 Act allowed them to recoup those costs through sales charges or “loads” imposed on investors at the time of purchase. By the early 1960s, 95 percent of funds had sales loads averaging about 8.5 percent. But there was a catch. The 1940 Act also allowed “contractual plans,” in which up to half of the first 12 monthly payments could consist of sales load alone—meaning early withdrawal could result in a 50 percent loss to the investor. In the 1950s, while the average sales load dropped from 9 to 8.5 percent, contractual plans proliferated to cover about 6.6 percent of total mutual fund assets.
The Wharton Report noted that shareholders did not benefit from volume stock purchases; the Special Study detailed who did. In the 1960s, New York Stock Exchange rules made no allowance for volume discounts—brokers charged a fixed commission to a fund for every share traded, whether singly or by the hundreds. Brokers doing block trades for mutual funds, therefore, made a lot of profit. In order to ensure that those profits continued, brokers often provided rebates, known as “give-ups,” to fund managers. The Special Study sanctioned some such “reciprocal business,” particularly the provision of free research by brokers in return for fund business, but it condemned blatant rebating, which benefitted brokers and fund managers but raised costs for everyone else and encouraged fund managers to needlessly reinvest accounts, or “churn.”20
Regulators were increasingly alarmed by churning. Some of it was spurred by innovations such as “swap funds” that avoided taxation, funds of funds, dual funds, and multi-advisor funds. But most of it came about as the “buy and hold” investment philosophy of the 1940s gave way to the “performance” cult of the 1960s.
Fidelity Investments opened in 1946, but founder Edward Johnson had deep roots in the conservative prewar Boston funds. In 1957 Johnson turned the Fidelity Capital Fund over to Gerald Tsai, who was anything but conservative. By the early 1960s Tsai had become the first celebrity fund manager and his success at actively trading to outperform the Dow had spawned many imitators. By the end of 1964 there were at least 20 “growth funds” with assets over $100 million. Largely due to this boom, turnover in the mutual fund market rose from 17.6 percent in 1960 to 46.6 percent by 1968.
The structural conflicts and sales excesses of mutual funds gained some notice beyond the SEC during the mid-1960s, particularly from class action lawyer Abe Pomerantz, who sued dozens of fund managers over brokerage commissions and insisted that mutual funds should be organized like conventional corporations. But with mutual funds looking like the general public’s way to share Wall Street’s “go-go years,” there was little public pressure for reform.
Manuel Cohen did not let a lack of public pressure for reform stop him. After becoming SEC Chairman in 1964, he made mutual fund reform his signature initiative. “It was sort of based on the idea that the industry had grown so huge,” Cohen’s executive assistant David Ratner recalled, “and the growth had caused these problems.”21 Dave Silver, who had just moved from the SEC to the ICI, saw the old dynamic still at work in the mid-1960s, a “residual fear in Washington, again coming out of the Great Crash, that if the mutual funds ever unwound for any reason it would lead to calamities in the marketplace as funds dumped their securities on the market to meet redemptions.”22 Despite all the scrutiny, the 1962 Wharton Study had made no specific recommendations, and the 1964 Special Study of the Securities Markets had been only a staff report to the Commission. Therefore, Cohen launched a Commission study with congressional recommendations the desired result. The Commission worked with the ICI and looked at a cross section of the industry, scrutinizing 33 companies representing about 27 percent of the market.
The result was Public Policy Implications of Investment Company Growth. The industry had more than tripled in size since the Wharton Report, now exceeding $38 billion. The Public Policy Study, therefore, more confidently estimated the effects of mutual funds on the larger market. The 1940 Act had been generally effective, the study found, but subsequent growth had “created a need for additional protections for mutual fund shareholders in areas which were either unanticipated or of secondary importance in 1940.”23
If there was an underlying argument in the Public Policy Study, it was that shareholders should retain a larger portion of their investments then lost to conflict of interest between trustees and fund managers, front-end load contractual plans, and “give-ups.” There was a barrier in the way, however. Market forces might have been expected to spur competition and lower costs, but in an effort to discourage unethical price cutting, section 22(d) of the 1940 Act expressly prohibited retail price competition (known as “resale price maintenance”) between those selling fund shares. The staff members who prepared the study backed repeal of 22(d), but the specter of net redemption stayed the Commission’s hand.24
Instead the drafters fell back on the supposition that if compensation was held down, managers and advisory firms might merge in order to increase efficiencies. Sales charges, on the other hand, could simply be set at levels more commensurate with those of the rest of the financial industry.
Cohen worked hard to bring the rest of the Commission into agreement, and in the end, the report made three legislative recommendations: first, that front end load contractual plans should be banned; second, that compensation of fund managers and advisory firms should be “reasonable” and enforceable by the courts; and third, that the ceiling on sales charges should be lowered to 5 percent. On December 22, 1966, the SEC submitted its report and recommendations to Congress.
Industry reaction was overwhelmingly negative. Contractual plans got little defense, but fund managers and more than a few economists made much of the arbitrariness of the second and third recommendations. How was “reasonable” compensation to be defined? What made a 5 percent sales charge more appropriate than the 9 percent set by the 1940 Act? The Commission could not answer those questions. The SEC, said one critic, “forgot its economics.”25 Undaunted, the Cohen Commission continued to believe it had workable solutions to the problems that had become so apparent during two decades of mutual fund growth.
(14) Information on investment companies from Report of the U.S. Securities and Exchange Commission on the Public Policy Implications of Investment Company Growth; Report of the Committee on Interstate and Foreign Commerce, Pursuant to Section 136 of the Legislative Reorganization Act of 1946, December 2, 1966, page vii. Information on value of stocks and bonds on registered exchanges is from U.S. Bureau of the Census, Statistical Abstract of the United States, 1969, Washington, D.C. 1969, page 457.
(15) Report of the U.S. Securities and Exchange Commission on the Public Policy Implications of Investment Company Growth; Report of the Committee on Interstate and Foreign Commerce, Pursuant to Section 136 of the Legislative Reorganization Act of 1946, December 2, 1966, page 3.
(23) Report of the U.S. Securities and Exchange Commission on the Public Policy Implications of Investment Company Growth; Report of the Committee on Interstate and Foreign Commerce, Pursuant to Section 136 of the Legislative Reorganization Act of 1946, December 2, 1966, page vii.
(25) Joel Seligman, The Transformation of Wall Street: A History of the Securities and Exchange Commission and Modern Corporate Finance (New York, 2003), 371.
(Courtesy of Stuart Kaswell; made possible through a gift from the family of Milton H. Cohen)
(With permission of Jonathan Cohen, the Honorable Susan Borman and the Lyndon B. Johnson Library and Museum)
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