In May 1967, propelled mostly by Manuel Cohen’s sense of mission, the SEC-drafted investment company legislation landed in the congressional lap. History repeated itself. The industry pushed back, and Congress called for compromise, with conservative reform the result.
As the hearings went on, the SEC and the ICI negotiated. Even though it had enlisted the help of former SEC chairmen James Landis and Ralph Demmler, the ICI knew, as David Silver put it, “there was absolutely no long term solution to the SEC’s legislative program except the enactment of a legislative program.”26 But the big guns and the delay ensured that there would be compromise. The centerpiece of the legislation and grounds for most of the negotiation were the excessive management fees that Cohen held responsible for the “steady increase in costs to investors.”27
The SEC’s solution had been a statutory “reasonableness” test; the compromise was creating a fiduciary responsibility, encouraging management firms to lower fees by making them subject to suit from either shareholders or the SEC. The SEC got the better of the deal regarding contractual plans—loads were required to be better disclosed and spread more evenly over the first four years of a contract. And funds had to create reserves to enable shareholders to recover fees exceeding 15 percent anytime during the first 18 months. Alan Rosenblat, a staffer in the SEC Division of Corporate Regulation, helped draft these provisions intended to severely curtail front-end loads. He recalled that “I think we hoped to kill it, but we didn’t realize how successful we’d be.”28
The final legislation also sought to reduce conflicts of interest between fund managers and shareholders, prohibiting any “interested person” with a relationship to fund management—including family, current or former legal counsel, and others designated by SEC—from serving as a fund director. There was also the conflict that the 1940 Act had created in section 22(d) by stipulating that all fund shares had to be sold at the same price. By foreclosing competition this provision returned large profits to traditional mutual funds that they used to underwrite sales costs. The SEC considered abolition of the provision but worried that funds with captive sales forces like IDS would benefit at the expense of independent brokers. Instead the commission pushed for a 5 percent ceiling. The final legislation left it up to the National Association of Securities Dealers to set a threshold for excessive sales charges.
The Investment Company Amendments Act, passed in December 1970, was a conservative reform, not merely because of what was compromised out of it, but also for what the SEC never even attempted. Many of the ills that pervaded the industry could have been alleviated by bringing market forces into play, not only by repealing section 22(d), but also by requiring funds to internalize their management like any conventional business, much as Abe Pomerantz insisted.
As these amendments were being hammered out, one of Pomerantz’s nemeses started a slow death. Reciprocal business or “give-ups” got into the crosshairs during a 1968 SEC investigation of New York Stock Exchange Rule 394 which kept NYSE members from trading off the floor. But even as Rule 394 worked to keep broker fees fixed and so grease give-ups for conventional broker-traded funds, the growth of the off-exchange “third market” and renunciation of give-ups by the funds with captive sales forces undermined the structure. In 1968 the SEC restricted give-ups. In 1973 the NASD barred reciprocal business entirely, although two years later Congress allowed fund advisors to pay higher commissions in return for research.
The 1970 Amendments were made with the specter of net redemption still lurking. At the time of the Public Policy Study, Commissioner Hugh Owens had resisted proposals to repeal 22(d), on the grounds that no one had determined what might happen. In 1970 Congress agreed, inserting a provision requiring the SEC to undertake such a study. By the time the SEC had done so in 1972 the specter had arrived—with a far different result than expected.
From the beginning, mutual funds consisted mostly of corporate common stock. The postwar decades were good for corporations, and the bull market of the 1960s good for their equities. Then came a 1970 market crash, inflation, and recession. In 1972 mutual fund redemptions were in excess of sales for the first time since the 1930s. As stagflation worsened and the market plunged again, mutual fund assets dropped from $56 billion in 1972 to $31 billion in 1974. One industry observer worried that “the fund industry as we know it is likely to disappear.”29
Managed equity funds did not disappear, but they did take a back seat as a host of innovative funds entered the once plain vanilla market—all with the blessing of an SEC now worried not about market growth, but about market decline. One of the first entries was the municipal bond fund. Introduced in 1961, bond funds started slowly but grew after the mid-1970s when meltdowns in particular municipal bonds encouraged the pooling of investments, and the 1976 Tax Reform Act formalized an exemption for municipal bond funds. But it was a later innovation that most fundamentally remade the market.
Regulation Q is largely unknown today, but during the 1970s it was every banker’s enemy. Part of the Glass-Steagall Act, Regulation Q imposed interest ceilings on savings accounts and prohibited payment of interest on checking accounts entirely. As inflation mounted to double-digits in the 1970s, depositors were desperate for an alternative, and they found it in money market funds. Pioneered in 1971, money market funds invested in short-term instruments like treasuries, commercial paper, and certificates of deposit. Devised to provide a safe reserve (the first was called “The Reserve Fund”) during inflationary times, they soon competed with banks. In 1976 big management firms like Fidelity and Dreyfus fielded popular funds, and there was $3 billion in money markets all told. Just four years later there was $80 billion.
Unlike other funds, money market funds were structured so that they would have a constant share value—bank trust departments preferred this because it conformed to the Uniform Principal and Income Act, and consumers found it easy to understand. Since their actual value could not fluctuate, money market funds were pegged at $1 per share by amortization valuation and penny rounding pricing. In 1977, the SEC, aware that money market funds were keeping the staggering mutual fund industry off the ropes, issued an exemptive order and an interpretive release approving these accounting rules. They were formalized in 1983 with exemptive rule 2a-7.
The combined result of money market competition and the SEC push to unfix commission rates revolutionized the equity fund market. In 1962 just over 3 percent of mutual funds were “no-load”—that is they charged no up-front sales fee. No broker would sell them because they provided no room for commission. When the boom ended and funds began to drop the load in order to become more competitive, it threatened the very structure of the industry. As one old-time broker wrote SEC Chairman Casey, “the no load fund concept destroys the salesman’s initiative as well as potential in the promotion of the Mutual Funds sold for a commission.”30
After May 1, 1975, when New York Stock Exchange commission rates were unfixed, there was little room for protest. Now forced to compete through negotiated commission rates, brokerages began to cut their least profitable lines, including external mutual funds, and develop their own products in house. In response the big mutual fund firms began to drop the load and internalize their sales forces. The Dreyfus Liquid Assets Fund—a money market fund competing with banks—removed its sales load in early 1974. Fidelity soon followed suit.
The last major innovation of the 1970s was in some respects the new realization of an age-old notion: if you could not beat the market perhaps you could buy it. In 1927 the predecessor of Standard & Poor’s raised the possibility regarding one investment company but noted, “of course, neither this trust nor any other buys ‘the whole market.’”31 Twenty-four years later John C. Bogle wrote a senior thesis at Princeton on “The Economic Role of the Investment Company” which suggested that funds should “make no claim for superiority over the market averages.”32 Twenty-four years after that, Bogle was fired from Wellington Management and took the opportunity to create Vanguard 500, the first widely available index fund.
The birth of the index fund industry was predicated upon the insight that it might be possible to match the market by investing in representative stocks, or “indexing.” As with money markets there were varying approaches—Bogle’s was to index by capitalization. Again the SEC was relatively generous with exemptive relief. A few years later, when Vanguard sought to create an in-house fund of funds, the SEC General Counsel’s office advised against it, and two commissioners dissented, but the Commission approved the exemption.
Along with the realization that it was possible to mirror the market came a sharp break with past mutual fund philosophy. The net redemptions of the 1970s disabused the investing public of the notion that sharp mutual fund managers could consistently outperform the market, and salesmen lost their best pitch. Henceforth, mutual fund shares would more often be bought than sold.
In 1977 Commissioner Philip Loomis contrasted earlier concerns about investment company growth with “a problem now as to whether investment companies can grow enough.”33 One factor that sharply limited growth, he suggested, was the fact that the 1933 Act limited mutual fund ads to brief, basic descriptions such as those found in “tombstone” advertisements usually employed for securities issues.
During its 1972 hearings on 22(d) the SEC took up the growing problem of distribution, positing that more conventional advertising might create a demand “pull” in place of the sales “push” more typically employed in the postwar decades. But there seemed little to be done—the tombstone restriction was written into the 1933 Act. The ICI kept the issue alive, however, and a solution was found in authority provided by Congress back in 1954 enabling the SEC to approve the omission of certain types of information in a share prospectus (which was essentially an advertisement). This “omitting prospectus,” approved by Rule 434 (d) two years later, allowed funds to engage in more conventional mass media advertising with the caveat that they could be subject to antifraud prosecution. As hoped, the new advertising rules stimulated price competition among funds.34 Another innovation that came out of the 1972 hearings was the creation, under section 205 of the Advisers Act, of what became known as the “fulcrum fee.” In essence it sought to help the staggering mutual fund industry recover by allowing a new type of carefully defined performance fee.
Another 1970s development produced even greater demand pull: the emergence of defined contribution plans. The postwar decades had seen the crest of employer-funded pensions, technically known as defined benefit plans. The Keogh Plan emerged as an alternative in 1962. An even more widely used option came in 1974 after deindustrialization had hollowed out many pensions, prompting Congress to pass the Employee Retirement Income Security Act (ERISA). Only a year after ERISA created the individual retirement account, Americans had some $1.4 billion invested in IRAs—most of it in mutual funds.
One of the largest markets for mutual funds, however, came about accidentally after pension specialist Ted Benna realized that section 401(k) of the 1978 Tax Reform Act would allow employers to match employee contributions to retirement accounts, all tax-deferred. By the 1980s corporations were seizing the opportunity to discard expensive pension plans for 401(k) plans largely composed of mutual funds.
Meanwhile, the SEC under Harold Williams had begun to roll back what it considered excessive regulation imposed by the 1940 Act. In 1978 Williams created an Investment Company Act Study group. “The linchpin of the program,” that year’s SEC Annual Report noted, “is enhancement of the authority and responsibility of investment company directors, particularly disinterested directors, as primary overseers of management decisions.”35 By 1980 the SEC had revised some 25 rules, getting the Commission out of the way by substituting standards of conduct for prior SEC approval.
By that time, the specter of net redemption had vanished for good, and the mutual fund industry was in the middle of what Williams called “the most explosive period of growth in its history.”36 The Commission initiatives of the late 1970s helped, but Martin Lybecker, Director of Investment Management from 1978 to 1981 credited the 1940 Act with not only providing the flexibility required to permit the innovation of the 1970s, but also to ensure its own continued significance. “Without that exemptive authority,” said Lybecker later, “the Investment Company Act would have become irrelevant by 1960 or 1970.”37
(29) Matthew P. Fink, The Rise of Mutual Funds, An Insider’s View (Oxford, 2008), 78.
(31) Standard Trade and Securities Service, Vol. 45, No. 4, July 5, 1927, Edgar Higgins Papers, Harvard Business School Archives, Box 2.
(32) Robert Slater, John Bogle and the Vanguard Experiment: One Man’s Quest to Transform the Mutual Fund Industry (Chicago, 1997), 7.
(34) Joel Seligman, The Transformation of Wall Street: A History of the Securities and Exchange Commission and Modern Corporate Finance (New York, 2003), 375.
Moderator: Martin Lybecker
Presenter(s): Kenneth Berman, Kathleen Moriarty, Robert Plaze
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