4. Development and Regulation of Investment Funds in the USA
In 1990 a study of mutual funds industry written by W.J. Baumol, S.M. Goldfeld, L.A. Gordon and M.F. Koehn was published under the title "The economics of Mutual Fund Markets: Competition Versus Regulation". The authors review the history of mutual funds and their government regulation and criticize the existing approach which is in their view a source of inefficiency. Here is the brief summary of their book.
The first small investment companies came into being in the USA as early as at the end of the last century. However the real investment companies in the present sense of the word began to appear only in 1924. In 1929 shortly before the onset of the Great Depression there already existed 108 investment companies with 582 thousand shareholders and 3.03 billion dollars of invested capital. During the Great Depression, however, many investment companies went bankrupt and, consequently, in 1940 their number was reduced by about one third and their total capital by two thirds.
After World War II the number of companies began to grow rapidly again. Their number grew by 6 to 12 percent, the number of individual accounts in these companies by 10 to 13 percent and the capital invested by 17 to 18 percent a year. In 1970 there were some 400 investment companies in the USA with 11 million accounts and the total capital exceeding 50 billion dollars. Only 17 years later, in 1987 there were already almost two and a half thousand companies with more than 55 million accounts and the total capital approaching 800 billion dollars. Thus after banks investment companies have become one of the most significant financial intermediaries that at the same time also intermediate ownership of quite a substantial part of the American economy.
According to two different criteria investment companies are divided into the open and closed ones and diversified and non-diversified ones.
The closed investment companies usually issue and sell limited number of shares in order to raise capital for a predetermined investment purpose. If needed the closed companies may increase their equity, however, they are not obliged to repurchase on request shares from their shareholders. Shareholders may withdraw from the company if they find somebody willing to buy their shares. Thus the closed company shares are tradable on secondary financial markets and their market value can differ from the portfolio value under the influence of demand and supply.
On the other hand, the open investment companies, usually called mutual funds, accept new shareholders continuously and are bound by their statute to redeem on request any shareholders share at its net asset value , i.e. at the value of the portfolio divided by the number of issued shares. The shareholder in the open mutual fund may thus withdraw from the fund without having to seek a buyer for his shares on the secondary market. In order to pay the proper value of shares mutual funds have to calculate the net asset value at least once a day, but many of them do it every hour.
To make an investment company - open or closed - eligible for the diversified status it must fulfill the following condition concerning 75 percent of its shares: it must not invest in any joint stock company more than 5 percent of its own assets and it must not own more than 10 percent of the companys equity. The remaining 25 percent of its assets may be invested by the diversified company without any restrictions. Apart from the fact that diversification offsets investment risk it brings also certain tax benefits. If the investment company meets diversification terms and if it distributes at least 90 per cent of its pre-tax income to its shareholders it can avoid double taxation, i.e. it can pass the received dividends and capital gain to its shareholders without taxation. Naturally, most of the investment companies and especially the mutual funds are diversified.
In the USA majority of mutual funds are organized as corporations. Each mutual fund has its own specific investment objective and forms a specific portfolio of the purchased securities. It is an independent corporation which has its own manager and board of directors. However, such a fund is usually founded and administered by another corporation which is called the "adviser" to the fund. The adviser makes decisions on how to invest financial means procured by the respective fund, i.e. it maintains and updates the investment portfolio in order to achieve the investment objective of the fund. For these activities it receives from the fund an annual fee, most often as a percentage of the value of invested property. Apart from the advisory fee for the maintenance of portfolio the shareholders may be charged on their admission to the fund the so-called "sales load" and on their withdrawal the so-called "redemption fee" or "back-end fee.
Only rarely such an adviser is a legal body independent of the founder of the fund. Mostly both the officers providing advisory service and the managers of the fund are paid employees of the founding company. Very often the same adviser administers several investment funds with different investment objectives. Such a group is called a "fund complex". The largest fund complex in the USA today is the Fidelity Management and Research Corporation which administers more than 100 funds.
During the development proportions of various categories of investment companies changed radically. At the very beginning the closed companies prevailed. In 1929 the share of open companies in the capital of all companies was less than 5 percent. However, in 1940 this share increased to almost 40 percent, in 1960 to 90 percent and in 1987 it reached 97.4 percent. Apart from that a number of other structural changes appeared in recent years:
As a result of the growing competition sales loads and redemption fees decreased substantially or were entirely eliminated and the advisory fee was pushed down mostly below ½ percent a year. In 1970 the typical sales fee ranged still between 7.5 and 8.75 percent and almost 95 percent of all assets were invested in mutual funds requiring such a fee. But already in the year 1983 the percentage of funds not requiring the sales load increased to 73 and many of the remaining reduced their sales load to mere 4 percent.
Between 1972 and 1974 an increased inflation rate and a very unstable capital market conditions resulted in the 45 percent cut of investments in traditional mutual funds. These investments were recovering only very slowly in the following five years. As an innovation a new type of mutual funds investing in money market financial instruments instead of equity was created in 1974. The money market mutual funds began to grow very rapidly and in the period 1980 - 1984 they even overtook traditional mutual funds which, however, resumed their first position again after 1985. In the year 1987 454 billion dollars were invested in capital market mutual funds and 316 billion in money market mutual funds.
The growth of the total number of funds was accompanied also by a rapid growth of fund complexes. Only in the five-year period from 1982 to 1987 the number of complexes increased from 181 to 338 and the average number of funds per one complex grew from 4.02 to 5.88. At the same time the funds with an adviser different from the founder and administrator became more frequent. There were only 45 such funds in 1982 but in 1987 they already numbered 224, i.e. their share in the total increased from 6.6 per cent to 12.7 percent.
The last noteworthy feature of the development has been the rapid growth of various investment objectives. In 1970 there were only five different types of funds by their investment objective. In 1987 their number reached already 22. Complexes of mutual funds usually allow a cost-free transfer of their shareholders investment from one type of fund to another.
All these features of the development have proven that in the past twenty years the competition between investment funds achieved a very high level. As a result of this competition favorable investment opportunities arisen for general public, including the possibility to transfer the capital easily, quickly and without excessive cost between funds with different investment objectives and different advisers. It is true, however, that in the twenties and thirties the competition among investment funds was still insufficient.
Governmental regulation of investment funds is carried out in the USA by the Securities and Exchange Commission operating on the basis of Acts of 1933 and 1934. Already in the thirties it became evident that these acts did not provide adequate protection of small investors and investment funds against their abuse by advisers. Therefore a specific Investment Company Act was adopted in 1940 and it was supplemented with even more strict amendments in 1970.
The authors of the Act of 1940 and its amendments of 1970 were convinced that a small investor had in fact no possibility to replace the adviser of the fund even if this adviser charged excessive fees for his services. This was explained mainly by the fact that the founder, administrator and adviser of the fund is in great majority of cases the very same institution. Apart from that it is quite evident that in the twenties and thirties founders and administrators of some investment companies actually misused their position in various ways for their own enrichment. It was estimated that in these two decades shareholders were deprived of more than one billion dollars. Apart from relatively rare cases of direct frauds and embezzlements some of the administrators and advisers of the funds used for their enrichment a number of at that time legal but unethical methods.
Thus e.g. Dillon, Read & Co. applied the so-called pyramiding scheme. In 1924 it founded the first major closed investment company the U.S. & Foreign Securities Corporation with the total equity of 31 million dollars out of which 30 million were in preferred stock and only one million in common voting stock. The majority of preferred and one quarter of common stock was sold to public, however, Dillon, Read & Co. retained 5 million shares of preferred stock and 750 thousand shares of common stock which allowed it to control the total investments of 31 million dollars. In the second round Dillon, Read & Co. founded the second investment company U.S. and International Securities Corporation with the total capital of 63 million dollars out of which U.S. & Foreign purchased 10 million shares of preferred stock and two out of the three million shares of common stock. Thus Dillon, Read & Co. succeeded in gaining control over the total capital of 80 million dollars while investing less than 6 million dollars of its own capital. Other shareholders of these investment companies had no effective control over their operations.
Among the other forms of enrichment belonged: a) using investment funds as a cheap source of credits for founders, b) sale of less valuable founders stock to investment funds for excessive prices, c) pressure on investors to change funds often and thus generate both sales loads and redemption fees for the administrators, d) the so-called dilution of shares from which advisers could profit due to the slow dissemination of information before World War II.
In 1939 Securities and Exchange Commission submitted to the Congress an extensive study on investment companies in which it identified as sources of the major problems the following issues:
On the basis of this analysis the following requirements were incorporated in the Investment Company Act of 1940:
The requirement of extensive disclosure of information. Besides detailed information which has to be released on the registration, each investment company must send twice a year to its shareholders a detailed report on the financial situation, the status of portfolio, salaries of managers and fees paid to advisers.
The requirement of effective shareholders control of the management. All the shares of investments companies must be voting stock, certain decisions made by managers must be subject to the approval of the majority of shareholders and at least 40 percent of members of the Board of Directors of the investment company must be independent of the founder and adviser.
The requirement of a clearly formulated agreement between the fund and its adviser. This agreement must be in writing, it must include exact specification of fees paid to advisers by the fund, its duration must not exceed two years unless annually renewed by the Board of Directors or majority of shareholders and may be terminated at a two-month notice and without penalty.
The right of Securities and Exchange Commission to intervene in the activities of the fund with the aim to protect its shareholders. The Act does not explicitly sets limits for management and advisory fees, however, it gives the Commission the power to sue the advisers of the fund in case of "gross misconduct or abuse of trust " and to request fee relief to be imposed by the court.
In the sixties three more reports on mutual funds were prepared for the Congress, and namely the so-called Wharton Report of 1962 and two reports of the Securities and Exchange Commission of 1963 and 1966. These reports found that a number of regulations of the 1940 Act were not effective. Shareholders of mutual funds were in general apathetic towards their voting rights and attended general meetings only sporadically. Voting was mostly controlled by the managers through "corporate proxy machinery". Also unaffiliated members of Boards of Directors did not properly fulfill their role in the protection of interests of investors as required by legal stipulations. These unaffiliated managers only seldom challenged the decision made by the funds advisers.
These reports further state that the Act of 1940 did not establish an adequate mechanism for the courts review of the fairness of contracts between funds and their advisers. It was determined that the fees paid by mutual funds were higher than the fees for similar services paid by other clients and it was recommended that a more stringent criterion of "reasonableness" should be applied and the advisers should be requested to reduce the fees whenever economies of scale were achieved. It was also found out that high sales loads (8.5 percent and more) discouraged investors from choosing other funds and thus made it possible for advisers to maintain high advisory fees. It may be worth to mention that the size of sales loads was in fact maintained by the Act of 1940 which prohibited the sales agents to reduce sales loads fixed by the administrator of the fund.
On the basis of these reports amendments to the 1940 Act were adopted in 1970. These amendments did not change the legal regulation in any substantial way they only weakened some of the points while making others stronger. As concerns the Board of Directors the word "unaffiliated" was replaced with "disinterested". The amendments stipulated much more clearly the "fiduciary duty" for the mutual fund adviser and both the "Commission" and shareholders got the right to sue the adviser for violation of this responsibility if it required excessive fees. However, the decision what was to be considered excessive was left to the court. No strong regulation of sales loads was enacted in 1970 amendments.
One of the main consequences of the Act of 1940 and of its amendments of 1970 was a large number of very costly litigations. As the Act did not specify clear regulations of the size of fees most of these litigations were settled out of court, and from those actually tried, courts found most frequently for the defendant, i.e. the mutual fund adviser. In the period of 1960 to 1987 the plaintiff won only in four out of the total 69 litigations. These litigations demonstrated very clearly that courts were incapable of deciding the cases according to the rational economic criteria.
This was a brief summary of study of mutual funds written by W.J. Baumol, S.M. Goldfeld, L.A. Gordon and M.F. Koehn that was published in 1990. What are their conclusions?
Although before the War competition in the mutual funds industry was inadequate and therefore government regulation was needed to protect small investors, the situation changed radically in the post-war period. Competition between a large number of funds and their advisers resulted in a significant expansion of the choice for investors, in the reduction of advisory fees and sales loads and thus it freed investors from the dependence on a single manager and adviser. Investment in funds have become much more liquid so that even small investors can transfer them quickly and without greater losses not only between the funds of the same complex but also between funds administered by different advisers. In such a situation founders and advisers of mutual funds are not in a position to charge excessive fees or exploit small investors in any other way. In such a fierce competition the loss of reputation would mean an early end.
Baumol et al. point out that competition provides a far better protection of the small investor than excessive and thoughtless governmental regulation. After all it was the Act of 1940 which for a long time helped maintain high sales and redemption fees, thus hindering the transfer of capital between funds with different advisers and restricting competition between them. As a result instead of protection, governmental regulation left small investors to the mercies of exploitation. Moreover, governmental regulation caused reduction of efficiency of this branch by imposing on it inefficient organization and management structure and initiating a significant number of costly but in fact unsuccessful litigations.
Baumol et al. conclude that as in the other areas of the mature economy with fully developed competitive markets also in the mutual funds industry the time is ripe for deregulation. "Overall, our policy prescriptions suggest that a considerable dose of mutual fund deregulation will serve the public interest. We do not suggest that the industry should be left entirely to its own devices. The rules against fraud and misrepresentation clearly have an important role to play in providing protection to the public, and they should be enforced vigorously. There are, equally, no grounds on which to exempt any entity in the arena from the workings of the antitrust laws. Moreover, we propose the adoption of somewhat more severe disclosure rules than currently exist. Our proposed disclosure rules would provide investors and other interested parties all the information necessary that no questionable activities or decisions by advisers or others threaten or actually produce detrimental consequences for the legitimate interests of investors. But beyond vigorous execution of such rules, we see no need for any substantial regulation of the industry. We believe that here, as in other industries such as airlines and banking, unnecessary regulation can cause economic inefficiencies that must ultimately be born by the public in general and by investors in particular in the form of higher prices."