One course open to the defensive investor is to put his money into investment-company shares. Those that are redeemable on demand by the holder, at net asset value, are commonly known as "mutual funds" (or "open-end funds"). Most of these are actively selling additional shares through a corps of salesmen. Those with nonredeemable shares are called "closed-end" companies or funds; the number of their shares remains relatively constant. All of the funds of any importance are registered with the Securities & Exchange Commission (SEC), and are subject to its regulations and controls.*
The industry is a very large one. At the end of 1970 there were 383 funds registered with the SEC, having assets totaling $54.6 billions. Of these 356 companies, with $50.6 billions, were mutual funds, and 27 companies with $4.0 billions, were closed-end.t
There are different ways of classifying the funds. One is by the broad division of their portfolio; they are "balanced funds" if they have a significant (generally about one-third) component of bonds, or "stock-funds" if their holdings are nearly all common stocks. (There are some other varieties here, such as "bond funds," "hedge
* It is a violation of Federal law for an open-end mutual fund, a closed-end fund, or an exchange-traded fund to sell shares to the public unless it has "registered" (or made mandatory financial filings) with the SEC. t The fund industry has gone from "very large" to immense. At year-end 2002, there were 8,279 mutual funds holding $6.56 trillion; 514 closed-end funds with $149.6 billion in assets; and 116 exchange-trade funds or ETFs with $109.7 billion. These figures exclude such fund-like investments as variable annuities and unit investment trusts.
funds," "letter-stock funds," etc.)* Another is by their objectives, as their primary aim is for income, price stability, or capital appreciation ("growth"). Another distinction is by their method of sale. "Load funds" add a selling charge (generally about 9% of asset value on minimum purchases) to the value before charge.1 Others, known as "no-load" funds, make no such charge; the managements are content with the usual investment-counsel fees for handling the capital. Since they cannot pay salesmen's commissions, the size of the no-load funds tends to be on the low side.t The buying and selling prices of the closed-end funds are not fixed by the companies, but fluctuate in the open market as does the ordinary corporate stock.
Most of the companies operate under special provisions of the income-tax law, designed to relieve the shareholders from double taxation on their earnings. In effect, the funds must pay out virtually all their ordinary income—i.e., dividends and interest received, less expenses. In addition they can pay out their realized long-term profits on sales of investments—in the form of "capital-gains dividends"—which are treated by the shareholder as if they were his own security profits. (There is another option here, which we omit to avoid clutter.)}: Nearly all the funds have but one class
* Lists of the major types of mutual funds can be found at www.ici.org/ pdf/g2understanding.pdf and http://news.morningstar.com/fundReturns/ CategoryReturns.html. Letter-stock funds no longer exist, while hedge funds are generally banned by SEC rules from selling shares to any investor whose annual income is below $200,000 or whose net worth is below $1 million.
t Today, the maximum sales load on a stock fund tends to be around 5.75%. If you invest $10,000 in a fund with a flat 5.75% sales load, $575 will go to the person (and brokerage firm) that sold it to you, leaving you with an initial net investment of $9,425. The $575 sales charge is actually 6.1% of that amount, which is why Graham calls the standard way of calculating the charge a "sales gimmick." Since the 1980s, no-load funds have become popular, and they no longer tend to be smaller than load funds. i Nearly every mutual fund today is taxed as a "regulated investment company," or RIC, which is exempt from corporate income tax so long as it pays out essentially all of its income to its shareholders. In the "option" that of security outstanding. A new wrinkle, introduced in 1967, divides the capitalization into a preferred issue, which will receive all the ordinary income, and a capital issue, or common stock, which will receive all the profits on security sales. (These are called "dualpurpose funds.")*
Many of the companies that state their primary aim is for capital gains concentrate on the purchase of the so-called "growth stocks," and they often have the word "growth" in their name. Some specialize in a designated area such as chemicals, aviation, overseas investments; this is usually indicated in their titles.
The investor who wants to make an intelligent commitment in fund shares has thus a large and somewhat bewildering variety of choices before him—not too different from those offered in direct investment. In this chapter we shall deal with some major questions, viz:
1. Is there any way by which the investor can assure himself of better than average results by choosing the right funds? (Subquestion: What about the "performance funds"?)+
2. If not, how can he avoid choosing funds that will give him worse than average results?
3. Can he make intelligent choices between different types of funds—e.g., balanced versus all-stock, open-end versus closed-end, load versus no-load?
Graham omits "to avoid clutter," a fund can ask the SEC for special permission to distribute one of its holdings directly to the fund's shareholders—as his Graham-Newman Corp. did in 1948, parceling out shares in GEICO to Graham-Newman's own investors. This sort of distribution is extraordinarily rare.
* Dual-purpose funds, popular in the late 1980s, have essentially disappeared from the marketplace—a shame, since they offered investors a more flexible way to take advantage of the skills of great stock pickers like John Neff. Perhaps the recent bear market will lead to a renaissance of this attractive investment vehicle.
t "Performance funds" were all the rage in the late 1960s. They were equivalent to the aggressive growth funds of the late 1990s, and served their investors no better.
Before trying to answer these questions we should say something about the performance of the fund industry as a whole. Has it done a good job for its shareholders? In the most general way, how have fund investors fared as against those who made their investments directly? We are quite certain that the funds in the aggregate have served a useful purpose. They have promoted good habits of savings and investment; they have protected countless individuals against costly mistakes in the stock market; they have brought their participants income and profits commensurate with the overall returns from common stocks. On a comparative basis we would hazard the guess that the average individual who put his money exclusively in investment-fund shares in the past ten years has fared better than the average person who made his common-stock purchases directly.
The last point is probably true even though the actual performance of the funds seems to have been no better than that of common stocks as a whole, and even though the cost of investing in mutual funds may have been greater than that of direct purchases. The real choice of the average individual has not been between constructing and acquiring a well-balanced common-stock portfolio or doing the same thing, a bit more expensively, by buying into the funds. More likely his choice has been between succumbing to the wiles of the doorbell-ringing mutual-fund salesman on the one hand, as against succumbing to the even wilier and much more dangerous peddlers of second- and third-rate new offerings. We cannot help thinking, too, that the average individual who opens a brokerage account with the idea of making conservative common-stock investments is likely to find himself beset by untoward influences in the direction of speculation and speculative losses; these temptations should be much less for the mutual-fund buyer.
But how have the investment funds performed as against the general market? This is a somewhat controversial subject, but we shall try to deal with it in simple but adequate fashion. Table 9-1 gives some calculated results for 1961-1970 of our ten largest stock funds at the end of 1970, but choosing only the largest one from each management group. It summarizes the overall return of each of these funds for 1961-1965, 1966-1970, and for the single years
TABLE 9-1 Management Results of Ten Large Mutual Funds"
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