General Survey | The Prospectus | Sales Commission | Distribution Methods | mutual fund Distribution | Management Expenses | Redemption | How Big? | Who Owns Investment Company Shares and Why? | No-Load Funds | Specialized Funds | Canadian Investment Companies | Management Company Shares | Tax-Free Exchanges

GENERAL SURVEY

Open end investment companies are now generally known as "mutual funds", the terms being used interchangeably - you might need to note that should you be looking at the history of mutual funds while considering how to invest mutual funds. Un­doubtedly, the word mutual has sales value, for it is associated with savings banks and certain life insurance companies. In a number of ways, mutual fund companies are no more mutual than the ordinary commercial bank or industrial enterprise. This does not detract from their merits, but uninformed investors may misunderstand the implications of the word.

David Schenker, who testified at the Congressional hear­ings on the Investment Company Act and was counsel to the Securities and Exchange Commission in the preparation of its report on investment trusts and investment companies, stated the theory out of which the acceptance of the term undoubtedly arose: "Our concept of an investment company is that it is a mutual enterprise. The stockholders being on a parity, there ought not to be any conflict between the security holders of that type of institution. This ought to be a mutual enterprise, with one class, simple structure, no different than a bank, no different than an insurance company, no different than any other type of financial institution. They are all partners in a common venture. They all stand to gain or lose. There is no overreaching. There is no necessity for protection in situations where the common stock is under water and the funds really belong to the common stockholders." (Investment Trusts and Investment Companies, Hearings on S. 3580, Senate Committee on Banking and Currency, 76th Cong., 3d sess., 1940, Part I, p. 270.)

As you look at whether or how to invest mutual funds, it will help to know that mutual fund companies are management companies, and as defined in the Investment Company Act, they have two main traits:

1. Shares of mutual fund companies are offered continuously at prices which will net the fund amounts equivalent to the net asset value of each share outstanding at the time of sale. The price per share to the public or investor includes a commission to the underwriter, which is known as the load, cost of acquisition, cost of distribution, or distribution charge.



2. Mutual fund companies agree to redeem or repurchase their outstanding shares on short notice by paying the investor in cash the net asset value per share of his stock.

An underwriter, pursuant to a sales agreement with the fund, sells shares to the public through investment dealers or through his own organization.

The revolutionary innovations of the mutual fund investment company were introduced by Massachusetts Investors Trust in 1924. Until 1928, only State Street Investment Corporation fol­lowed suit, and many investors still think of mutual fund compa­nies as Boston or Massachusetts funds.

Types of mutual fund Companies

Mutual fund companies are classified, as already outlined, into three broad groups, which you will need to choose from when you invest mutual funds:

1. Common stock funds invest largely in a diversified list of common stocks. Investment policy varies, but the most impor­tant shifts usually are made among different groups of common stocks and individual issues rather than shifts from common stocks into cash, bonds, or preferred stocks. "Special situations" are of little significance; in this respect, they differ from a num­ber of closed-end companies.



2. Balanced funds attempt to provide a complete portfolio and invest more of their funds in bonds and preferred stocks. Less emphasis is placed on capital appreciation possibilities and more on stability.



3. Specialty funds may be broken down into three general classifications: The first type is the industry class, which mainly invests in common stocks of a single industry, such as aviation, chemicals, railroad equipment, or banks. The second type is made up of class-of-security funds, i.e., investments are con­fined to bonds or preferred stocks, or to special classes of stocks, such as low-priced common stock or second-grade railroad bonds. The third type consists of funds that concentrate invest­ments in geographical areas: Canada, South Africa, Europe, Texas, or New England. The stocks owned represent equities of companies that operate in these areas.

The remarkable growth of mutual fund investment companies is indicated by the following data (dollars in millions):

	Number of Companies At Year	Net Assets	Sales of Own Shares (millions)	Money Value of repurchase of Own Shares	Net Increase
1961	170	$22,789	2,951	$1,160	$1,791
1690	161	17,026	2,100	815	1,282
1659	155	15,818	2,280	786	1,494
1958	151	13,242	1,619	511	1,108
1957	143	8,714	1,390	405	984
1950	98	2,531	518	280	238
1945	73	1,284	292	109	182

The first half of the forties witnessed a big jump in the sale of shares. The net increase in sales increased moderately there­after for several years, slowed down for a number of years in the first half of the fifties, and then soared to an average of more than $1.3 billion annually in the five years 1957-1961. How large this figure is may be gauged in perspective. In the same five-year period, new issues of all common stocks exclu­sive of mutual fund investment company shares averaged only around $2 billion annually.

During 1961, common stock purchases by mutual fund investment companies alone totaled $4.0 billion and portfolio sales amounted to $2.8 billion. Total purchases for portfolios were around $4.6 billion, and portfolio sales amounted to approxi­mately $3.2 billion. At the end of 1961, investment companies, including closed-end investment companies, held in the aggregate 4.4 per cent of the outstanding New York Stock Exchange listed stocks. It is estimated that at the end of 1961 the number of shareholders reached 2.9 million.

THE PROSPECTUS

Consider while you look at invest mutal funds that as is true of other companies that wish to offer securities pub­licly, an investment company must file a registration with the SEC. When the Commission has permitted the registration statement to become effective, the shares may then be sold. A copy of the prospectus, which is a condensation of the registra­tion statement, must be given to the investor to make a sale legal.

The basis of the Investment Company Act, as has been stated before, like the Securities Act of 1933, is an insistence upon full disclosure to the investor of all material facts concerning com­panies, which intend to offer stock to the public. The Commis­sion does not "approve" the security in the sense of passing on the wisdom of raising the funds or on the merits of the partic­ular type of Investment Company that has been organized, nor does it pass on the policies of management with respect to in­vestments.
The purpose of the prospectus is to make available to the investor the facts upon which an intelligent opinion may be formed. Unfortunately, too many investors do not read the prospectus, or cannot understand the most elementary financial language. Since 1933, the prospectus has undergone many changes. Today, it is a streamlined document, generally brief, and written as simply and clearly as the subject matter permits.

The Commission has gone far to prevent the prospectus from being misleading even though it is a selling document intended to persuade the prospective investor. In an early proceeding, the Commission decided that the type used to name the cus­todian of an investment company was so prominent that it pre­sumably was intended to impress the reader with the standing of the financial institution and lead him into thinking that the custodian would have a voice in the fund's management. Re­vision was required.

The prospectus generally contains the following information about the fund: its objectives and features, investment policy, the securities being offered, management personnel, dividends and capital gains distributions, investment powers and restric­tions, redemption or repurchase of shares, pricing of shares, portfolio, and financial statements, including a record of per share income and changes in net asset value.

The prospectus may also present information about such mat­ters as a cumulative investment program and reinvestment of dividends; withdrawal plans, and even photographs of the mem­bers of the board of directors. If the new company requires purchase of securities from an approved panel, the prospectus may list that along with the names of the members of the ad­visory board, if such a board is provided for, and also set forth the advantages of ownership of shares in the company. Every prospectus states the names of the transfer agent and custodian, legal counsel, auditors, and underwriter or distributor.

Many investors regard the statement that the shares being offered may be obtained at the net asset value, plus a sales charge equal to 8 or 8.5 per cent (or less as the case may be) of the offering price, scaled down depending on the size of the purchase, as the most important information in the prospectus. This is open to question, but it certainly serves to avoid mis­understanding and surprise on the part of the investor who is willing to read the entire prospectus.

Supplementing the prospectus, underwriters produce a tre­mendous quantity of sales material in the form of leaflets, cir­culars, and pamphlets, as well as motion pictures and, recently, phonograph records. The kind of material is limited only by the requirements of the SEC and the Investment Company Institute and by the ingenuity of those preparing the material.

Despite all these sources of information, investors must not allow themselves to be persuaded that it is essential to buy the shares of an investment company before they have had an op­portunity to read the prospectus.

SALES COMMISSION

The precise method of determining the net asset value of each share of stock and its offering price is often set forth clearly in the prospectus of mutual fund companies. Generally the form resembles the following example:

Computation of net asset or liquidating value—based on closing
market prices of securities as of December	31,1960
Market value of investments	$5,000,000
Cash and other Assets	250,000
Total assets	$5,250,000
Less reserves and liabilities	50,000
Net asset value of 1,000,000 shares outstanding	$5,200,000
Net asset value per share	5.20
Offering price to the public	5.62
Sales load (distributor's commission) per share	0.42
Sales load (per cent of offering price)	7.47%
Sales load (per cent of net asset or liquidating value)	8.08

This computation needs little elaboration as far as invest mutual funds is concerned. In most instances, mutual fund companies have chosen at the start to fix the capital­ization so that distribution is effected at a low price per share, merely on the assumption that the investor prefers to have a substantial number of shares for each $100 invested. This tend­ency was more common in the early thirties than in recent years. It will be observed that the load is computed in two ways: (1) in relation to the net asset value and (2) in terms of the offering price itself. The net asset value is usually deter­mined by valuing the securities at the last sales price if such sales price can be determined or by the last bid price or at the mean of the closing bid and asked prices. Ordinarily, the board of directors has discretion to establish other methods for deter­mining market value if no quotations are available.

Quotations for mutual fund investment company shares are found in metropolitan newspapers under "Mutual Funds" in the over-the-counter department. Bid and asked prices are shown. The bid is the price that may be obtained in the event the investor wishes to redeem his shares. This is also the net asset value per share (less a small fee in some instances). The asked, or offering, price is the price that must be paid and in­cludes the sales commission. Again, these quotations are dif­ferent from the quotations for other securities, which are determined by supply and demand.

DISTRIBUTION METHODS

When considering invest mutual funds, consider that the fact that mutual fund-company shares are sold continuously has produced a unique selling mechanism. Generally, an mutual fund company management enters into an agreement with the principal distributor pursuant to which the distributor is granted the exclusive right to distribute the company's shares. These shares are purchased by the distributor or underwriter at a price, which will net the company an amount equal to the net asset value. The distributing firm, which is usually associated with the original organizer and sponsor of the investment com­pany, thus becomes the principal underwriter.

The distributor-underwriter may distribute the investment company stock to the public through its own organization. More usually, its selling activities are confined to interesting security dealers in the investment company. They in turn distribute the investment company stock to the public. Out of the total load of 8 to 8.5 per cent of the offering price, the principal distributor may retain around 30 per cent. A principal underwriter or dis­tributor sometimes employs wholesalers, who are granted ex­clusive territorial rights; and the wholesalers in turn distribute to retail dealers. Retail dealers are supplied with selling liter­ature and copies of the prospectus.

A distributor organization may be by-passed if the investment company wishes to sell its shares directly. Another type of dis­tribution has emerged in recent years, known commonly as the plan company. These companies specialize in offering investors participation in contractual plans involving the purchase of mutual fund-company shares.

At one time, the method of distribution contained serious flaws in the form of additional "hidden" loads. The principal underwriter, distributors, or retail dealers were able to engage in reckless trading in connection with the sale of shares because of their ability to choose among two or three days' prices in taking down shares to fill orders from investors. The Investment Company Act empowered the SEC to correct selling practices, which might result in dilution of mutual fund shares or in added costs or in unfair trading profits to insiders and dealers.

The net asset value is usually computed twice daily. The determination is made at the close of trading on the New York Stock Exchange each business day and is accomplished by di­viding the number of shares outstanding into the company's net worth (the excess of its assets over its liabilities). The net asset value is determined by the appraisal of securities listed on national exchanges and the mean between the bid and asked prices of unlisted securities. The public offering price based on such determination is usually effective from 4:30 p.m. on that day to 2:00 p.m. on the next business day. The net asset value is again determined as of 1:00 p.m. and the public offering price is effective from 2:00 p.m. to 4:30 p.m. on that day. Owing to market changes, the net asset value at which shares are pur­chased from the company may be greater or less than would be the case if a new determination were made and simultane­ously became effective at the time of purchase. To the extent of this difference, there may be a diminution of, or an increment to, the net asset value of the outstanding shares when such purchases are made.

Neither the principal underwriter nor the dealers are per­mitted to benefit themselves by a price change. If so instructed by the customer, however, dealers may and do withhold placing orders so that the customer may benefit from a pending price change. Ordinarily, the degree of dilution resulting from these provisions is minute. Wellington Fund, Incorporated, provides that new shareholders may be admitted only on terms of ap­proximate equality with existing shareholders, and the fund may increase or decrease the price on the basis of an estimate made on the Dow-Jones composite average when this average fluctuates 2 per cent or more.

In most instances, the offering price of shares applies to a single transaction of less than $25,000; the sales commission is reduced from 8 to 6 per cent on transactions between $25,000 and $50,000, and is further reduced on larger transactions. The reductions may also apply to aggregate purchases made within a period of, say, thirteen months, if a letter-of-intent form is signed.

The load, or selling commission, has been criticized as being excessive. It is often compared with the brokerage fees in stock transactions. Some in the industry object to the need to display the load prominently in the prospectus, since it often presents the most difficult hurdle in effecting a sale. The industry, how­ever, is generally reconciled to the publication of the selling commission.

Comparison is frequently made with the commission rates on stock exchange securities. If, for example, the investor were to buy a number of odd-lots, representing an investment of $5,000, or four different stocks in amounts of 50 shares each and they were selling at $25 per share, the aggregate cost, aside from the one-eighth point odd-lot differential, would be ap­proximately $75, which is substantially less than the cost of acquiring an mutual fund investment company share. (The differ­ential was larger before commission rates were increased.) In the event of sale, however, similar costs would be incurred, whereas mutual fund investment company shares generally may be redeemed without cost.

Other comparisons have some relevance. The National Asso­ciation of Securities Dealers considers a 5 per cent mark-up on unlisted securities reasonable, or more accurately, con­siders a charge of more than 5 per cent clearly unreasonable. Many new common stock issues, particularly those of smaller companies, and especially issues of companies that have not previously offered securities to the public, involve underwriting commissions of 6 to 10 per cent, and substantially more on offer­ings of less than $1 million.

It is best to admit that the cost of acquiring the stock of mutual fund companies is larger than the purchase of standard listed stocks and to point out the advantages of ownership. In­vestment companies therefore now emphasize the services pro­vided, such as the dividend reinvestment privilege, withdrawal plans, elimination of problems of safekeeping of a large number of certificates, simplification of bookkeeping for tax purposes, and the like. These advantages are not of prime importance, but they are at least worth mentioning.

The existence of a substantial selling commission, it should be added, makes the mutual fund company unsuitable as a me­dium of trading. This is a consideration that cannot be under­lined too emphatically. The industry has not hidden this consequence. With my own conviction that attempts to beat the market are utterly pernicious for anyone but the skilled, experienced trader, I regard the sales commission in one respect as being wholesome, for it acts as a deterrent to overtrading. The investor, however, ought to realize that the selling com­mission equals the return from ordinary income, i.e., interest and dividends, for a period of two years or more. Payments from profits realized on the sale of securities cannot be relied on to make up the difference. Accordingly, I urge the investor to buy mutual fund company shares with the purpose of holding them for at least two years, and preferably with the thought that capital appreciation will result from economic growth rather than market fluctuations. Otherwise, disappointment and resentment will arise.

I am, then, not prepared to call selling commissions generally excessive. Although the cost of acquisition is an expense that must be paid when the shares are acquired, the investor who holds his shares for a number of years, or more or less indefi­nitely, can properly prorate the cost in his mind on an annual basis. As in the case of other commodities, reduction in the cost of distribution and marketing would be advantageous if the quality of the product remained unimpaired. Low commis­sion rates on high-grade securities have often encouraged the sale of inferior or speculative securities because of the larger commissions that could be earned.

MUTUAL FUND DISTRIBUTION

To eliminate or at least cut down the volume of improper sales literature used in the selling of mutual fund shares in par­ticular, the SEC with the assistance of the National Association of Security Dealers, which is a self-policing organization, adopted a Statement of Policy in 1950. It set forth the types of advertising and sales literature that were considered to violate the standards of the Securities Act of 1933 (the "Truth in Se­curities Act") and the Investment Company Act of 1940. The Statement of Policy was amended in November 1957.

Pursuant to the Statement of Policy, concerning invest mutual funds, it is considered mate­rially misleading for sales literature to:

1. Imply a percentage return on the investment in the shares of investment companies, except when the rate of return is ex­pressed as a ratio of dividends paid from net investment income and adjustment has been made for capital gains distributions. Distributions from net investment income and distributions from other sources must not be combined. Nor is it proper to represent or imply that an investor will receive a stable, continuous, dependable or liberal return, or that he will receive any specified rate of return.



2. Represent that an investor's capital will increase or to dis­cuss such matters as accumulation of an estate, protection against loss of purchasing power (particularly effective when the cost of living is rising), diversification of investments, finan­cial independence or profit possibilities without pointing out the market risks inherently involved in the investment.



3. Refer to the registration or regulation of investment com­panies without explaining that this does not involve supervision of management.



4. Exaggerate the significance of the services of banking in­stitutions as custodians of securities or as transfer or disbursing agents, fail to state the character of the limited role of the custodian whenever the advantages of these services are dis­cussed.



5. State or discuss the redemption features of investment company shares without explaining that the value of the shares on redemption may be more or less than the cost of the shares to the investor.



6. Represent that shares of an investment company are simi­lar to or as safe as government bonds, insurance annuities, sav­ings accounts, or life insurance, or possess the features of a debt security; or that the management of an investment company is under the same type of investment restrictions or is operated under limitations such as are imposed on savings banks and
   insurance companies, except as investment policy is restricted by the investment company itself as set forth in the registration statement.



7. Use any comparison of an investment company security with any other security or security index or average without pointing out: (a) that the particular security index or average and period are selective; (b) that the results disclosed should be considered in the light of the company's investment policy and objectives, the characteristics and quality of the company's investments, and the period selected; and any other factor necessary to make the comparison fair, (c) To represent that investment companies are direct sources of new capital to in­dustry or that a particular investment company is such a source unless the extent to which such investments are made is dis­closed.



8. Use any chart designed to depict the record of an invest­ment company over a specific period of time unless it complies with standards previously set forth to avoid misleading infer­ences as to the performance history of an investment company.



9. Make extravagant claims regarding management ability or competence or to imply that investment companies are operated as "cooperatives" or to represent or imply that investment com­pany shares generally have been selected by fiduciaries.



10. Use the phrase "dollar averaging" or similar phrases with­out making clear that the investor will incur a loss if he discontinues the plan when the market value of his accumulated shares is less than his cost; that the investor is investing his funds primarily in securities subject to market fluctuations; that the method involves continuous investment in such shares at regular intervals regardless of price levels; that the investor must take into account his financial ability to continue such a plan through periods of low price levels; and that such plans do not and cannot protect against loss in value in declining markets (any table depicting the operation of a continuous plan must use the actual offering price and must include the total cost and liquidating value of the investment at the end of each year or any shorter period shown in the table).



11. Fail to include, in any sales literature that does not state the rate of the sales charge, the following statement in a sepa­rate paragraph in type as large as that used generally in the body of the piece: "There is a sales charge to the investor in­cluded in the offering price of the shares of this company. For details thereof and other material information see the prospectus.



12. Fail to include in any sales literature used to encourage investors to switch from one investment company to another, or from one class of security of an investment company to an­other, the substance of the following statement in a separate paragraph: "Switching from the securities of one investment company to another, or from one class of security of an invest­ment company to another, involves a sales charge on each such transaction, for details of which see the prospectus. The prospective purchaser should measure these costs against the claimed advantage of the switch."

Other condemned practices deal with comparisons of indus­try performance against company performance unless the make­up of the portfolio of the particular company is such that its performance will generally approximate that of the industry. Reprints from published articles relating to investment com­panies are prohibited unless the material complies with the Statement of Policy and is not taken out of context so that its intended meaning is altered. When the Statement of Policy was made public, the industry was compelled to discard large quan­tities of material.

Not all of the specific material considered misleading is of equal importance. In the main, the Statement of Policy is un­ambiguous, and only a few of the more important practices designated as misleading require further discussion.

The Statement of Policy is directed against the use of such phrases as "a dividend check every month," "dependable in­come," "you receive continuous income," since the income of investment company shares depends on the company's income from portfolio securities. Usually, the holdings are largely com­mon shares, on which dividend payments vary with business fluctuations. Another practice that is misleading is the failure to point out that registration and regulation do not involve ac­tual supervision of management or investment policies. Among the most widely used promotional devices were charts to illus­trate the history of an investment in a particular company, but it was found that those charts usually covered a period arbi­trarily selected to show a substantial growth of the company. The source of distributions was not clearly delineated, and the charts were based on net asset value and therefore did not com­mence with the investor's true cost.

Many sales made will continue to be consummated because of confidence in the sales representative. No matter how care­ful the effort to protect the public by raising the standards of sales literature, there are numerous investors who either will not take the trouble to read and understand a prospectus and supplemental information or do not have the basic knowledge on which to formulate intelligent judgment. The "intelligent investor," (Benjamin Graham, The Intelligent Investor, New York: Harper & Brothers, 1959) to borrow the title of an excellent book, is not so common as its author assumes. The Statement of Policy, never­theless, is a step forward. Sales may be reduced as a result of the changes in sales literature, for few other industries are charged with similar responsibilities, such as pointing out, for example, that the possibilities of growth of capital invested also involve the possibility that the investor's capital may diminish.

These condemned practices are not all-inclusive. It is im­proper to make any extravagant claims regarding management ability or competency or to imply that investment companies are operated as cooperatives. Not all of the prohibitions are of the same significance. Undoubtedly, the Statement of Policy helps to protect the investor. The investment company industry itself has recognized the temptation to use unwise if not fraud­ulent selling methods. For example, The Investment Company Institute has prohibited its members from using published material that unfairly attacks ordinary life insurance and has adopted a new code of ethics that broadly regulates the ac­tivities of its members.

The widespread use of charts and tables prompts a word of caution. The investor must note carefully the caption accom­panying the chart. If dividends received are reinvested, the number of shares held will increase more rapidly than other­wise. This is an advantage if stock prices rise, but may involve a greater exposure to risk if the market trend is downward. Ad­justment should be made for income taxes payable on cash dividend payments even if such dividends are reinvested.

The investor must not allow himself to be captivated by the rise in the cumulative value of the shares. The statement that "this period was one of generally rising common stock prices" is worthy of attention. The investor should also heed the state­ment accompanying the chart that the results indicated are not a representation that the same results will be obtained in the future from an investment in the fund today.

No matter how careful the effort to protect the investing pub­lic, many will be misled by overzealous or unscrupulous sales­men. Others will be disappointed because they have expected "too much too fast" and have not taken the trouble to read the prospectus. It is a hopeful sign that courses in investing are multiplying rapidly. It is also noteworthy that newspapers and periodicals are giving more space to investment companies. Neither the SEC nor the investment company industry can protect the public as well as the investor himself through in­telligent judgment.

Abuses have been rare. In one instance, the SEC filed an action charging gross misconduct and abuse of trust in respect to a registered investment company. It was alleged that certain of the defendants had entered into a contract with a fund to act as investment advisors. In this capacity, they agreed with an employee of a brokerage firm that the latter would receive a large amount of brokerage commission over a five-year period. These and other arrangements were concealed from members of the board of directors. The defendants engaged in the im­proper practice of selling portfolio securities to realize a uniform and predetermined amount to be distributed to share­holders of the fund quarterly as capital gains. No consideration was given to whether or not the growth potential of a given investment had been fully achieved as set forth in the stated investment policy of the fund, apparently so as to increase sales commissions and management fees and to promote further sales to existing shareholders.

The management contract was subsequently acquired by a reputable, experienced group after a proxy fight, but in the meantime redemptions were large and the investors had been injured. One of the curious bits of evidence was the rapid growth of the fund despite an exceptionally heavy selling charge and other fees and the extraordinary success in selling shares of the fund, which seemed to be attributable to the appeal of capital gains distributions*.

 * A. Wilfred May, a critic of capital gains dividend payments had the fol­lowing to say concerning "illusions about yield" in the Commercial and Financial Chronicle, May 21, 1959: "In the area of dividends the lay fund-holder is, without realizing it, whole-hoggedly immersed in speculation. The fund man­agements in their dividend payments differentiate as clearly as they can between the portions derived from ordinary investment income and capital gains. Never­theless, the run of shareholders have come to regard the capital gains sweetening of the real recurring net income which is now down in the 2-to-3% range, as part of their annual investment yield."

MANAGEMENT EXPENSES

Until recently in invest mutual funds, selling commissions have received much more attention than management expenses, although the investor incurs the first but once, whereas management expenses recur annually. Management expenses tend to average about 0.5 per cent of net assets and to equal 15 to 18 per cent of gross income. Now that assets are in the area of $15 to $18 billion, these ex­penses are significant sums. Ratios among investment compa­nies vary considerably, with the larger funds generally having the lower ratios.

REDEMPTION

In addition to the fact that mutual fund shares are offered con­tinuously, another distinguishing characteristic of such com­panies is the agreement to repurchase shares at their net asset value at the option of the investor, who usually can receive his check in not more than seven days.

The method of computing the net asset value for redemption is exactly like that for computing net asset value to determine the offering price, with the exception that the selling commis­sion, or load, is omitted. Thus, if net assets have a value of $10 million and 1 million shares are outstanding, the net asset value per share would be $10.

The repurchase agreement, in effect, transforms the balance sheet of an investment company into a reservoir from which the investor can draw at will and, in general, without penalty. It is easy to understand the attractiveness of this feature. In­vestors have found that the assets of an industrial company, railroad, or public utility company as stated on the books are one matter, but it is an entirely different matter to attempt to realize that book value on the market.

The existence of the repurchase provision has exerted some influence on investment policy and excited fears about its con­sequences in periods of crisis. Investment policy has been in­fluenced in two ways by this unique feature. Management, aware of the withdrawal privilege, has nearly always held fairly substantial cash resources. Nevertheless, the position of mutual fund companies has not usually been radically different in this respect from that of closed-end companies. Both groups are eager to hold only a moderate amount of cash in order to avoid a statement showing sizable assets un-invested or represented by short-term bills. Secondly, investment managers are more likely to confine their attention to well-known securities be­cause of the possibility of being required to liquidate in order to meet heavy turn-ins. In the SEC investigation referred to in Chapter Three, the issue was raised whether the redemption provisions would invite liquidation and so create a standing weakness. The question was answered by O. M. W. Sprague, a member of the Advisory Board of Massachusetts Investors Trust this way: "I should only think it was a weakness to the extent that it might induce us to confine ourselves a bit more, and to a little greater extent, to readily marketable securities than would otherwise be the case. That is insofar as we hold some of the large and well known companies we are able to sell them, and we have a certain amount of cash and borrowing power."

In short, the fear arises that because the mutual fund investment company in a sense holds itself out as a bank, it may be thought of by the investor as a source of ready cash. Would mutual fund companies be able to meet an emergency created by a panic? If an army of stockholders stepped to the paying teller's win­dow, would not the necessary selling create a panic? mutual fund companies, unlike member banks of the Federal Reserve Sys­tem, have no institution to which they can turn for assistance.

The Investment Company Act itself protects investors against the suspension of the redemption privilege or postponement of the date of payment of redeemable (mutual fund) securities for more than seven days except: (1) for any period during which the New York Stock Exchange is closed, other than customary week-end holiday closings, or during which trading on the New York Stock Exchange is restricted; (2) for any period during which an emergency exists as a result of which disposal by the company of securities owned by it is not reasonably practicable or it is not reasonably practicable for such company fairly to determine the value of its net assets; or (3) for such periods as the Commission may by order permit for the protection of security holders.

The Commission is authorized to determine the conditions under which trading shall be deemed to be restricted and an emergency shall be deemed to exist. In other words, no matter how unconditional the phraseology may be, the contract pro­visions are subject to the Commission's authority under the Investment Company Act.

Experience to date indicates that redemption has not been a problem, although a number of severe tests have occurred dur­ing the past fifteen years. Not only has no incident or period led to any consideration of suspension of the redemption privi­lege, but the fear that redemption might exceed new purchases over a protracted period, and thus serve to impair stock prices seriously, has had no justification to date in experience.

A drastic decline in stock prices took place on September 3, 1946. The SEC prepared a report on the day's trading. No wave of redemption followed the decline in stock prices, which car­ried the Dow-Jones industrial average down from approximately 189 to 179 in one day. During the three months ending Sep­tember 30, 1946, mutual fund companies sold approximately 89 million shares of their own for $81 million and repurchased only 35 million shares at a cost of $33 million. On September 3, 1946, investment companies bought 57,000 shares of stock and sold 14,000, thus helping to stabilize prices.

When South Korea was invaded on June 24, 1950, the Dow-Jones industrial average declined almost 7 per cent. Trading was heavy. Sales of new mutual fund company shares during the week totaled almost $9 million and exceeded redemptions by about $800,000. Portfolio purchases amounted to $13.8 million, whereas portfolio sales were less than half the value of the purchases, or $6.2 million.

Again, when the stock market declined on the news of Presi­dent Dwight D. Eisenhower's heart attack, redemptions did not present a problem. During the week ending September 30,1955, the value of mutual fund share purchases amounted to $22.5 mil­lion, whereas redemptions amounted to $10.1 million.

In other periods of falling stock prices during recent years, such as October 1 to 21, 1957, and September 1 to 30, 1960, the decline in the Dow-Jones industrial average amounted to approximately 7.3 per cent, and the experience of mutual fund companies was essentially similar to that which had marked earlier declines.

No one can foretell what might occur in the event of a pro­longed decline in stock prices covering a period of years. Since mutual fund investment companies began to be important in the stock market, so-called bear markets, or periods of sharply de­clining markets, have not lasted for long periods. Perhaps, the persistent investment of mutual fund funds has been at least a small factor in this development. At any event, in no single month have the sales of new shares been exceeded by redemp­tions, an impressive record.

As a percentage of net total assets, redemptions are smaller than in earlier years, when assets were lower, as the tabulation on page 59 shows.

It is expected that redemptions will rise gradually in several years because numbers of investors who bought shares will reach an age when expenditures exceed income, and such in­vestors will draw upon their shares. An offsetting factor will be the growing number of investors with accumulation plans, who add steadily to the flow of funds into investment com­panies.

WHEN YOU INVEST MUTUAL FUNDS: HOW BIG?

Bigness in an industry often coincides with financial strength, important technological resources, and a favored position with respect to its ability to secure new capital. A cardinal principle in the relation between government and industry is the preser­vation of competition. Sometimes, bigness is obtained at the sacrifice of flexibility. Investors nevertheless have shown their preference for the stocks of big industrial companies.

Some of the advantages of bigness in other areas are carried over to investment companies. Large companies are better able to reduce the ratio of operating expenses to net assets or invest­ment income; yet they can spend freely for research. A company with sizable holdings of stocks may more easily establish close relations with managements, and company officials are more likely to be attentive to its requests for information.

The following tabulation shows some of the biggest invest­ment companies in terms of net assets:

		Net Assets (thousands)
		Dec. 31, 1960	Dec. 31, 1950
mutual fund companies:
	Massachusetts Investment Trust	$1,508,349	$44,889
	Investors Mutual, Inc.	1,599,213	215,939*
	Wellington Fund, Inc.	1,133,540	154,487
	Incorporated Investors	299,523	96,781
	Fidelity Fund, Inc.	397,579	43,420
Closed-end companies:
	Tri-Continental Corporation	412,382	86,654
	Lehman Corporation	296,177	112,335
	Madison Fund	119,992	37,225**
	United States and Foreign Securities Corp.	95,889	74,582
	Adams Express Co.	93,101	47,036

* September 30,1950
** June 30,1951

Mutual fund companies, once they attained popularity, became larger than closed-end companies. Only a few mutual fund com­panies, among them The Lazard Fund, Incorporated, and State Street Investment Corporation, do not continuously offer addi­tional shares. Competition is keen. Newly formed companies with sponsorship that has the confidence of the investor can grow rapidly. Sometimes, a vigorous sales policy seems to have greater weight in determining growth from new sales of shares than relative performance.

Large companies sometimes are thought to be less mobile than smaller investment companies. Although the stock market has continued "thin" when judged by the activity of the late twenties, sales of large blocks of shares are made successfully through secondary offerings and special distributions, and often-large blocks may be obtained from other institutional investors. Probably the most serious drawback of bigness (and this ap­plies to investment companies with assets of $50 million as well as $500 million) is that they cannot make open-market pur­chases of stocks of smaller companies on the scale desired.

As to small investment companies, the issues of newly or­ganized companies must be examined by the careful investor, since the organizations have no performance record. Companies that have remained small may lack proper distribution, or their records may be mediocre. If costs are extraordinarily high be­cause the company is small, this is a factor to be considered, unless its results have been exceptional or some special reason exists and the condition is temporary.

Study of the long-term records of investment companies in this country and in Britain fails to disclose a causal relation be­tween size and performance. I do not believe that the investor should buy or reject the stock of an investment company merely on the grounds of its size. There seems to be no ideal size in the operation of either closed- or mutual fund investment companies.

WHO OWNS INVESTMENT COMPANY SHARES AND WHY?

According to the National Association of Investment Com­panies, at the end of 1960 there were approximately 2.9 million shareholders in investment companies. Ten years earlier, it is estimated that there were probably not one fourth as many. At the end of 1961, shareholder accounts exceeded 5.3 million, and the number of accumulation plans at the close of 1961 is estimated at 1.7 million, an increase of almost 300,000 during the year.

A comprehensive study of mutual fund company stockholders showed the following (The Mutual Fund Shareholders (New York: National Association of Invest­ment Companies, April, 1958)):

Median figures:
	Age	55.0
	Family income in a recent year	$6,542
	Value of holdings	$4,171
	Number of funds held	1.2
	Amount of most recent purchase	$963

Other assets:
	Number of corporate stocks owned directly	3.7
	Value of corporate stock holdings	$8,187
	Bank accounts and United States Savings Bonds	$3,344
	Life insurance in force	$8,497

Among other facts shown in the study are these: 25.0 per cent of the stockholders were professional people and only 7.8 per cent were salesmen; families with incomes of $15,000 and more annually held 15.0 per cent of the value of mutual fund holdings, whereas families with incomes up to $5,000 held 19.6 per cent; when holders were classified by age, persons sixty years of age or older constituted 37.3 per cent of all owners of suchsecurities; cash holdings (29.5 per cent) and salaries were the two main sources from which the most recent mutual fund-share investment was made. Apparently, the public has reached the same conclusion that I have; there is no inconsistency in holding both the stocks of individual companies and investment company shares. The major objective cited for the purchase of mutual fund-company shares was future retirement income. Ap­proximately 25 per cent were looking for a better return on savings.

A significant part of the study covers the investment company features which investors preferred. Half of the investors who replied to the questionnaire cited diversification as the primary advantage of owning investment company shares. Other reasons also were cited:

PERCENTAGE

	Diversification	54.6
	Management	25.0
	Convenience	8.0
	Marketability	7.0

Both the average initial purchase and average holding of mutual fund shares have tended to rise over the years. A number of funds now point to the sizable holdings of their shares by college endowment funds, pension funds, charitable institu­tions, trade unions, and other large investors. It is difficult, however, to ascribe significance to the geographic distribution of holders and new investors.

Widespread ownership of investment company shares pre­sents the same problem of stockholder-management relations that confront investors in other securities. Full and frequent publicity, at any rate, has been cemented into the policies of investment companies. On the whole, they have done a com­mendable job in this respect. An investment company official has said: "We deal with the public's money, and therefore we live in a glass house."5 Owners of investment company shares are not exempt from the lethargy, which characterizes American stockholders in general. If only a few instances of reprehensible conduct or questionable practices have crept into the operation of investment companies, it is not due to any demonstrable watchfulness by investors.

Most investors are pleased to note substantial holdings of an investment company's shares by officers and directors and per­sons associated with the underwriters. Stockholder management is an asset. In dealing with money, readiness to risk one's own resources is a test not to be dismissed lightly. A number of funds now have stock option plans for members of their staffs, for they have found such plans a helpful means of retaining able people.

NO-LOAD FUNDS

As you consider how to invest mutual funds, consider that a number of mutual fund investment companies sell shares without charging any sales commission, or load, or premium over the net asset value per share, or make only a nominal sell­ing charge. Such funds originated with investment-counseling firms. These firms usually do not accept accounts with a value of less than $100,000 and charge a minimum annual fee of $500. Obviously, the minimum fee would be entirely out of propor­tion for investors with $5,000 to $10,000 (or even substantially more).

Instead of turning away smaller accounts, it seemed natural to organize a corporation to be used as a composite fund for investors with less money than those who could afford to retain investment counsel on their own. Purchases of shares of "no-load" funds may be made only from the company rather than through investment dealers or agents. In all other respects, these mutual fund companies are similar to other mutual fund investment funds.

A number of the principal no-load funds are listed below along with their date of formation and net assets as of December 31, 1961:

5 Dorsey Richardson, former president of the National Association of Invest­ment Companies, in an address at the annual meeting of the Association, New York, October 13,1960.

	Year Of Incorporation	Net Assets (millions)
De Vegh Mutual Fund	1953	$20.1
Energy Fund	1952	15.1
The Johnston Mutual Fund	1947	16.8
Loomis Sales Mutual Fund	1947	81.3
T. Rowe Price Growth Stock Fund	1950	39.9
Scudder, Stevens & Clark Fund	1928	77.9
tein Roe & Farnham Stock Fund	1958	15.8

No-load funds have not grown as rapidly in assets or in num­ber of shareholders as have many mutual fund companies, whose shares can be acquired only upon payment of the usual selling commission. Most of the sales effort of no-load funds is limited to newspaper and periodical advertising. In a way, the slower growth of these funds is comparable to experience with savings bank life insurance. Like insurance, mutual fund shares need to be sold; buyers apparently must be persuaded by sales effort and by salesmen.

What about the results of no-load funds as compared with the results of mutual fund investment company shares generally? Some no-load funds have done exceptionally well; others have had mediocre records. To date, evidence does not warrant the conclusion that the performance of no-load funds is inferior to that of other investment companies. On the other hand, except for saving the sales commission, no advantage has been estab­lished in the purchase of no-load fund shares.

SPECIALIZED FUNDS

As indicated by the classification, a number of funds follow the policy of concentrating their holdings rather than diversify­ing them. Originally, such funds generally bought shares in one field, such as the chemical, automotive, or railroad industry. Over the years, specialization has fallen into the following cate­gories: by industry—e.g. chemical, insurance, automotive, rail­road; by geographic location—investments localized in Texas, Canada, South Africa; and by type of security—preferred stocks, corporate bonds, convertible bonds, and even municipal bonds.

Variations upon these classifications also exist. Some funds use the word growth in their titles to show that their investment policy subordinates income to capital appreciation. Recently, the popularity of the electronics industry has given rise to the organization of a number of funds that invest in the securities of companies in that field. Similarly, other funds specialize in companies engaged in the so-called space-age industries. The recovery of Western Europe led to the formation of a company specializing in the securities of enterprises operating in that area.

The investor looking at how to invest mutual funds thus has a wide choice among specialized funds. But what about the underlying principle of specialization? Are specialized funds more or less desirable than diversified funds? Unfortunately, no blunt yes-or-no answer can be given. I must admit some reservations (perhaps "prejudices" would be more accurate) about specialized funds. If diversification lies at the very heart of the investment company principle (as I believe it does), then the further we get from diversification the more we depart from one of the basic justifications for the investment company. In fairness, one should add that some specialized funds really cover a very broad field. For example, a fund that presumably specializes in atomic energy issues is authorized to and does invest in oil, building materials, natural gas, metal, and automobile company stocks, or in companies primarily en­gaged in these industries.

Once again, the answer lies with the investor. So long as he is well informed, the decision about investing is his own. If he prefers to buy into a company specializing in gold mining or convertible securities, or in companies with operations in Flor­ida, he will find some company that meets his requirements.

One might add that as some investment companies have de­parted from the principle of diversification, so some insurance companies have departed from the earlier types of insurance to provide a wide variety of types of protection that meet different purposes.

CANADIAN INVESTMENT COMPANIES

As in the case of the United States, Canada has experienced growth in the formation of both closed-end and mutual fund in­vestment companies. A certain number of closed-end companies were organized in the twenties. The first mutual fund company was formed in 1932 by Calvin Bullock, an American firm. Since that time other mutual fund companies were formed which were aimed, for the most part, at satisfying the investment objectives of Canadian investors. In 1952 a number of mutual fund funds that specialized in Canadian securities were organized for distribu­tion to investors in the United States. The earliest of these funds differed from their American counterparts only in this special­ization in Canadian stocks and bonds.

Late in 1953 a new kind of fund was approved by the SEC forsale in the United States. These funds would retain and reinvest earnings rather than pay dividends, thereby affording substan­tial tax advantages to United States investors—particularly those in high income tax brackets, who could forego current income in the expectation of capital gains. The major requirements im­posed upon these non-resident owned (NRO) companies were (and still are) that they be incorporated and operated in Can­ada but be at least 95 per cent owned by non-Canadians. Secu­rities and cash owned by the fund were required by the SEC to be kept in the United States. At the end of 1959, the combined total assets of the nine NRO companies then in existence amounted to $396 million.

What are the various tax advantages which these companies can offer?

1. Since no dividends are paid, so long as a United States citi­zen retains his shares no United States tax liability is incurred.



2. If these shares are held for at least six months, profits on liquidation are not taxable at ordinary income rates but at the lower capital gains rate.



3. Under Canadian law, capital gains are not regarded as tax­able items of income.



4. The NRO companies can choose between two tax treat­ments:



1. They can pay a 15 per cent tax on all net investment income, and there will then be no further tax liability to the Canadian government by the fund; or



2. The company can pay the regular Canadian corporate tax rate of 21 per cent on the first $25,000 earned and 50 per cent on the balance exclusive of all dividends. Dividends received by Canadian corporations from other tax-paying Canadian corporations are not taxable. If this latter choice is made, an investor must pay a 15 percent Canadian withholding tax on whatever portion of his proceeds represent undistributed dividend income of the fund.

Despite the tax advantages mentioned, the great stock of natural resources, and the reasonable expectation of considerable long-term economic growth in Canada, the recent down-drift of the Canadian economy has made it difficult for the NRO companies to meet earlier expectations. It must be remembered that the investor in NRO funds has to be able to forego current income and that he must be willing to assume the inherent risks of investing in any growth situation.

MANAGEMENT COMPANY SHARES

Mutual fund investment companies usually have contracts with a management company. This organization provides investment advice on a fee basis. The management companies also gen­erally are the underwriters or "sponsors" of the fund or group of funds. Management fees and underwriting commissions run into large sums when the assets of the funds managed amount to several hundred million dollars and sales of new shares reach many millions of dollars annually. Until 1959, with one excep­tion, the shares of management companies were closely held and not traded publicly. In fact, the Securities and Exchange Commission frowned on public offerings of such shares because of provisions in the Investment Company Act. It contended that changes in control could be made only on the basis of book value of the management companies, which was slight outside of the value of the management contract itself. The views of the Commission were not upheld in litigation.

Beginning with the spring of 1959, a number of the owners of management companies sold part of their stock through pub­lic offerings. Several management company stocks sold much higher than the price at which the shares were first offered, but later issues were not as successful. In part, the stocks suffered from indications of opposition to the practice of maintaining the annual management fee at a fixed level (say, 0.5 per cent of net assets) regardless of the size of the fund. Although the cost of sales is generally proportionate to the size of the sales that have been made, it is obvious that the cost of research and other management expenses does not rise in a ratio equal to the increase in net assets. For example, management costs do not differ substantially when the assets of a fund have risen from $100 to $300 million.

It has been suggested that ". . . it is rarely asked whether an­other advisor might be able to render equally competent service at lower cost. Control of investment advisors has been trans­ferred and non-voting stock issued at prices obviously based on the expectation that the advisor will continue its services to a particular fund at what might be termed monopoly prices." (Address of Edward N. Gadsby, then Chairman of the Securities and Ex­change Commission, before the Committee on Corporate Counsel of the Boston Bar Association, Boston, April 13, 1960.)

Numerous suits were brought in the courts against mutual fund investment companies, which sought the cancellation of man­agement contracts as well as damages and an accounting of fees. Some complaints alleged that officials who served as directors of both a fund and an affiliated management or advisory com­pany stood in a conflict-of-interest position.

Although a scaling down of management fees as total assets mount may well be reasonable and shareholders are admittedly prone to approve contract renewals without too much thought, it must also be recognized that shareholders have the opportu­nity to know the facts and that their purchase and holding of stock are voluntary. The basis of the Investment Company Act is disclosure of the facts.

If the prevailing practices border on wrongdoing or injury to shareholders, the SEC can be expected to take the initiative to obtain prosecution of offenders or Con­gressional modifications of the law.

Why did almost all the groups holding underwriting agree­ments and management contracts sell part of their holdings within a short period of time? Their reasons were varied no doubt; the problem of taxes on estates after their owners' death; the desire to take profits during a period of high prices, espe­cially for securities bearing the tag "growth stocks"; the possi­bility of lower future prices; and potential competition from variable annuities.

I suggest that investors looking to invest mutual funds bear this in mind. Whatever the merits of management company shares, they are entirely different from investment company shares. Management companies do not own, directly or indirectly, the securities of the funds, which they manage or sell. Management companies depend on advisory fees and commissions; the shares of their companies do not increase in value merely because of general industrial and economic growth, and if redemptions were to exceed new sales, fees and commissions would shrink.

TAX-FREE EXCHANGES

The tax-free exchange is a relatively recent innovation, which appeals primarily to larger investors. The plan involves the for­mation of an investment company in order to take advantage of a ruling of the Internal Revenue Service to the effect that an investor willing to exchange his own holdings for shares in a newly organized investment company might make such an ex­change tax-free. The exchange privileges obtain only while the fund is being formed, ordinarily, for a period not longer than between sixty and ninety days. The first fund that began opera­tion under Section 351 of the Internal Revenue Code, which permits contributions of assets tax-free when a new corporation is organized, was Centennial Fund, Incorporated.

In these cases, the fund's management lists acceptable stocks in the prospectus with the right reserved to include the shares of other corporations than those named. The management of tax-free funds may have to limit the surrender for exchange of certain stocks if their total threatens to exceed the 5 per cent limitation on holdings of individual shares. Decisions must also be made as to the industries and stocks that the fund chooses to invest in. Once the initial offering is completed, no additional shares may be accepted. No additional shares may be sold for cash, except shares issued when the investor reinvests dividend distributions at the new asset value.

In one of the first of the new funds, the average investment was $125,000, and the minimum deposit ranged between $15,-000 and $25,000. The appeal - as far as how to invest mutual funds is concerned - is that in addition to acceptance of a capital gain that may be largely tax-free, is diversification while deferring payment of the capital gains tax. These funds illus­trate the importance of taxes as a factor influencing investment decisions.