ALTHOUGH there have been investment trusts in operation in this country for over forty years, they have not until recently enjoyed any prominence, nor have large amounts of capital been invested in them. The idea was really first developed in Great Britain and had already attained considerable proportions as early as 1880. The investmenttrust plan as conceived by Mr. Robert Fleming, who is now possibly the most important English investment-trust manager, is more or less typical of the entire movement at that time. Coming from Dundee to New York as a mercantile clerk, Mr. Fleming was greatly impressed with the possibility of investing funds in this country, particularly in our then rapidly growing railroads. It was possible for him at that time to borrow money in England for as low as 3 per cent and then turn around and lend it to the American railroad companies, taking their firstmortgage bonds for as high as 6, 7, and indeed 8 per cent. Obviously the profits for the promoters and common shareholders were very large, and the movement expanded rapidly. By 1888, eighteen of these trusts with a capital of over £23,000,000 were listed on the London Stock Exchange. By 1890 a trust ‘mania’ was under way. For some years the British debt had been steadily reduced; capital had continued cheap and abundant; the investment trusts had been uniformly successful, paying large dividends, and there had been rapidly mounting quotations for their securities.
Referring to this ‘boom’ in the investment-trust plan, the London Economist for April 6, 1889, remarks that ‘although successful with the public, the companies have not in some cases been able to make a very favorable start in business, for they have followed so fast upon each other’s heels that they have experienced great difficulty in purchasing proper investments. The supply of really sound securities is in many directions so very limited that any decided increase in the demand at once causes a considerable advance in prices . . . indeed so rapid has been the advance that it is stated several of the new trusts have been unable to effect purchases and are rather doubtful as to the direction in which their money shall be invested.’
These words have certain interesting applications to the present situation. As a result of the conditions described by the Economist a variety of abuses arose. The pyramiding process, or superimposing of one company on top of another, increased rapidly. For example, the Anglo-American Debenture Company was responsible for the creation of thirteen different but interconnected trusts at this time. This in itself might not have been objectionable had it not resulted in the manipulation of accounts, the creation of corners, and a great deal of general manoeuvring in order to sustain and increase the market value of the securities of the various trusts. In my opinion there is to-day in this country a large and well-known investment trust whose shares are selling for far more than their intrinsic or liquidating value, which has continually managed its portfolio so that it can show the greatest possible profits and thereby obtain the greatest market value for its shares, regardless of their real worth. Generally speaking, in this trust during the past year the good securities that have appreciated in value have been sold and the poorer ones retained or increased, simply to show profits.
The Economist tells us that this is exactly the game they were playing in England almost forty years ago. In 1890 the Baring crisis marked the beginning of a long period of difficulty for the investment trusts. It is interesting to note some of the expedients resorted to by the managers of the tottering trusts at this time. Mr. J. Edward Meeker, economist of the New York Stock Exchange, in an interesting paper on the subject, cites the following instance. ‘The “Imperial and Foreign Investment and Agency Corporation,” with a “ strong board ” of directors, saw fit to carry the valuations of their holdings at cost instead of at market prices, and on this basis to declare a dividend which absorbed £20,000 of their fictitious revenue balance of £32,409. The long-suffering auditor revolted and refused to shoulder further responsibility for the company’s accounts.’ By April 1891 the ordinary and deferred shares of ten of the more important trusts had declined in the market on an average of 34 per cent. In February 1893 the Economist made the following commentary: ‘It may be said with truth that, having sown the wind, they (the trusts) are now reaping the whirlwind. Week after week evidence accumulates proving only too forcibly that those responsible for the management of these trusts have based no inconsiderable part of their operations upon false principles, with the inevitable result that, after a more or less brief period of apparent prosperity, losses and difficulties have arisen.’ Scandal followed close on the heels of financial difficulty. It turned out that the banking house of Murietta and Company ‘had agreed to subscribe for 12,000 shares of the “Imperial and Foreign Investment and Agency Corporation” provided the latter would purchase from it certain securities which it had been unable to sell elsewhere. These depreciated £114,358 while in the trust’s possession. What stirred the ire of the shareholders was that despite their losses the trust, directors, and managers had made fortunes.’1
It was not until 1896 that the Economist noted ‘the upward movement in prices of trust securities generally.’
I have given at some length the history of the difficulties of the investment trusts in England because I strongly believe that unless we avoid these and other errors and false principles we shall inevitably go through a similar period of disaster and disgrace. If such a period should come, the wellrun trusts will suffer with the bad as they did in England forty years ago. Of course, the honest and ably managed companies would emerge from the difficulties eventually. Even during the worst period in England ‘ proof was afforded of the innate soundness of the investment-trust idea when properly administered.’ Of the thirty-one leading trusts of the time studied by the Economist, seven were able to make headway against the completely adverse current of conditions. In the hope and belief that we shall profit by the example of the older trusts and escape the worst of their difficulties, I shall now try to point out what in my opinion are some of the present dangers. Before doing so, however, I should like to emphasize the fact that the honesty and ability of the management are paramount and that good practices can be completely vitiated by dishonest and unsound investments.
Of the investment trusts of which I am speaking I propose to recognize two broad classes. First, those whose primary idea is the borrowing of money at a rate lower than that at which they can lend or invest it, and which in their investment programme follow a very wide diversification. Second, those that do not follow such wide diversification and that buy with the idea of appreciation, or that have attempted to buy securities which are cheap and will go up over a period of years. In England these two classes are generally differentiated as ‘trust companies’ and ‘finance companies.’ In this country we have tended to group them all under the general category of investment trusts. Both types have advantages and disadvantages that appeal variously to different investors. The broadly diversified trust has relatively small holdings in a great many issues. It attempts to secure a cross section of the various securities of the United States or of the world. Its particular advantages are that it permits small investors to participate in the ownership of a widely diversified group of securities, thereby obtaining such benefits as go with wide diversification. By its very nature, however, it is attempting to secure a representative average; it cannot, therefore, hope to turn in more than an average performance. Now the primary object of buying into an investment trust should be the desire to have expert and constant management which can do better than the average. As we have seen, however, a very broadly diversified portfolio means average results, and therefore the purchaser of the securities of such a trust cannot expect the full benefits of managerial ability. Of course, in fairness it should be said that poor management cannot do as much harm following wide diversification as otherwise.
There is a restriction in the by-laws of one investment trust which provides that as soon as the trust has $5,000,000 it shall have at least four hundred different issues. In contrast to this, the trust indenture of the Investment Managers Company of New York provides that it shall not have more than thirty issues. The first company has by its policy of diversification attempted to obtain security. The Investment Managers Company by its opposite policy has, however, obtained greater security. No one can get an issue into the portfolio of the Investment Managers Company without proving to the directors that it is not only good, but better than one of the existing issues for which it is to be substituted.
In the other company almost any security will get by. The pet issue of each director and officer can find its way in. Director A passes director B’s security, although he may not be very enthusiastic about it, so that director B will not blackball his issue. Another disadvantage to the highly diversified portfolio is either the inability of the management to follow closely so many issues or the expense of so doing. One of the worst of some of the present abuses is the ignorance and lack of attention of some investment managers. An investment-trust manager should know far more about the companies in which his money is invested than the average investor. This, I am afraid, is not always the case, and obviously it is far more expensive to follow closely and thoroughly a list of securities spread all over the face of the globe than a list restricted to a limited group of the best investments. I think it fair to say that the average highly diversified trust does not closely follow its list, but relies on its policy of diversification to save it, and, therefore, cannot produce more than an average showing.
In pointing out the difference between these two types of trust, I have already touched on one of the cardinal abuses — inattention. Of course, this evil may apply to the trust with a more limited and selected portfolio. I should also like to point out that it may apply to those trusts run by the big banks and brokerage houses. They may be honest and they may be able, but before their securities are bought one wants to be sure that they will continually apply and reapply that ability to the running of the trust into which one may be buying.
I think the worst cases of lack of attention come where the managerial control rests in rather numerous hands. Concentration of control with extensive powers is a feature of the utmost importance, avoiding the delay and lack of positive action that usually result when many individuals holding diverse opinions attempt to translate their ideas into action.
Some months ago I was asked by an investment house if I would consider running an investment trust that they had sold to the public some time before. During the course of the discussion I asked if I might see the portfolio. In examining this, I noted a very large block of the shares of a company which, as a banking house, they had recently acquired and sold to the public. I asked the gentleman with whom I was talking whether, if I were to advise them on their portfolio, and if I could convince the directors that the shares of another company in the same industry were a preferable investment, they would make the exchange. He replied, ‘No, not necessarily. This trust is part of our general machine, and if the selling of these shares adversely affected―and Company we would not make the sale.’ And yet the securities of this trust were sold to the public, whose money was being used not for the best interests of the men and women who had supplied the funds, but for the best interests of - and Company. This case brings up two common abuses to which the investment trust is now being put. First, that of being run for ulterior motives and not primarily for the best interests of the shareholders; second, that of being used as a depositary for securities that might otherwise be unmarketable. There are, of course, certain trusts that have been formed with avowedly ulterior purposes. Such procedure is obviously beyond reproach. It is only when a trust says it is formed to accomplish one thing and then attempts to do another that it becomes an abuse.
The practice by which a house of issue sells a part of its own underwriting to its own trust, although not necessarily unethical and unsound, is extremely dangerous. Those trusts run by banks and brokers are particularly subject to this temptation. In my opinion such companies should have a provision or a firmly established policy that they will in no way deal with themselves as principals; that if they wish to acquire part of an issue in which they as a house may be interested they will have to acquire it from some entirely outside source.
Some months ago, in testifying before a committee of the New York Stock Exchange, I was asked to state briefly what were, in my opinion, the present abuses in the investment-trust movement. My reply was: (1) dishonesty; (2) inattention and inability; (3) greed.
It is of the last of these that I now wish to speak. You may be asked to subscribe to a trust that is both honestly and ably run, and yet find it inadvisable to do so simply because there is nothing in it for you. All the profits go to the promoters and managers.
There are an infinite number of ways whereby this unduly large slice of the spoils is kept by the insiders. They may own all or a very large percentage of the equity stock; they may have warrants and options; or, more rarely, they may be able to take out the money in the form of expenses or managerial fees of one sort or another. There certainly is no ethical objection to promoters and managers getting away with all they can in the way of profits. Free competition is bound to keep this down to a reasonable figure. The objection comes when the amount so to be taken out is not clearly set forth. The most common method of accomplishing this result on the part of promoters is an exceedingly complicated capital structure. There are many investment-trust prospectuses in which it takes literally hours to figure out just how profits are to be divided. To those not trained in finance the task becomes impossible, and the promoters have accomplished their purpose. Certainly a clear statement of how the money is supplied and the profits divided, together with a simple, straightforward capital structure, is highly desirable.
Another danger, usually the result of greed, takes the form of a very large funded or floating debt or an excessive issue of preferred stocks. Very often the managers and promoters receive their compensation and profit in the form of common stock for which they have paid little or nothing. There is nothing to criticize in this procedure if it is clearly and simply stated so that all can easily understand. As is pointed out in such cases, the management receives nothing until it has earned and paid some fixed percentage on the senior securities. In other words, the compensation is dependent upon the success of the enterprise. But the difficulty is that the management or promoters have put up only a very small percentage of the total funds. If the enterprise is a complete failure, they have little or nothing to lose. It is natural, therefore, that they should take the attitude of ‘Let’s either win big or win nothing.’ This they accomplish by a very heavy pyramiding process. I do not believe that there are many people who with only $100 equity would, as a general practice, proceed to borrow and buy anywhere from $800 to $1000 worth of securities, and yet this is exactly what many investment trusts are doing to-day.
There is another difficulty to which pyramiding leads. With very heavy fixed charges and preferred dividends to meet, the management is under the constant necessity of producing a large dollar income the first and every succeeding year of operation with which to meet the relatively large fixed charges. This pressing necessity to produce immediate and constant income forces the investment of a large proportion of the funds in securities of a less desirable type.
A danger that I have already spoken of I should like to touch on again. There are a great many trust indentures, by-laws, and more or less formal policies that provide a variety of restrictions, the basic purpose of which seems to be to prevent, in the case of dishonest or incapable management, a complete dissipation of the funds.
Such a motive is praiseworthy, but all the restrictions in the world will not mitigate the evils of poor management, and about all they can do is to restrict the efforts of good management. Is it not probable that excess restrictions which we may place on the investmenttrust manager during a period of rising prices may be entirely wrong for a changed period of declining prices? I believe that no principles and restrictions should be developed so rigidly that they may not be changed at any time in order to conform with the best judgment of the management.
There are a great many other dangers confronting the investment trusts, but there is only one other I wish to mention here, and that is the excessive market price to which, in my opinion, the shares of certain trusts have been bid. To say what is a fair price for such securities I find extremely difficult — indeed, I do not know. I do think, however, that there are a few principles which may aid us in this determination.
Where the assets of an investment trust are not grossly overvalued, I should say that its various securities are at least worth the net liquidating value, or what would be realized in actual liquidation. The difficulty comes in saying how much more than the liquidating value the securities may be worth. I can think of only two factors that might bring this out. The first is the factor of management, and the second is the ability of the trust to borrow money at low rates of interest. If, for example, the X Trust can borrow $5,000,000 at 5 per cent for twenty years, that ability undoubtedly has a present market worth. Similarly, the ability of the management to make money in excess of the current rate of return over a period of years also has a present value. When, however, I find the shares of a very large trust selling in the market for nearly three times their liquidating value, particularly when that liquidating value is figured from a grossly inflated portfolio value; when there is no possible value to be added through funds borrowed at a low rate; and when, on top of it all, the management has in my opinion demonstrated inability and possibly dishonesty, I am inclined to think the shares somewhat high.
What can be done about these abuses? I should say that the remedies are publicity and education. Every industry has its abuses and dangers, and many industries present far more alarming hazards than the investment trust. Before touching on these remedies I should like very briefly to say a word about what purports to be remedial legislation. There has been much discussion of this topic, and many states have already gone far in setting laws on their statute books. Just as in the case of charter restrictions, about all these laws can do is to hamper able management and fail to protect the public against inability and dishonesty. No law can replace the necessity for investors to think intelligently and to investigate a situation before investing their money. We have had many examples of the evils of overregulation in other fields, and it would indeed be unfortunate to hamper by laws that cannot accomplish their purpose so valuable an instrument of finance as the investment trust. All that legislation should do is to require a degree of publicity that will enable any investor to form a sound opinion. It should not require publicity that would interfere with the honest and successful operation of the trusts.
Eor the publicity that not only should be required, but is good policy for the trust, I should suggest the following provisions. First, a clear statement should be made showing exactly where the control lies and who constitutes the active management. Second, it should be shown exactly how and in what proportion profits and losses are divided, particularly the existence of options, warrants, calls, and the like. Third, the investment policy of the managers should be made plain by figures giving the percentages invested in the various classes and types of securities.
There has been much discussion of the advisability of requiring that complete portfolio holdings be revealed. Arguments in favor of revealing them include the following points: —
1. The trust cannot be called and ceases to be a blind pool.
2. Dishonest or mistaken investment policies are more quickly revealed.
3. Public confidence is increased; the trust is ashamed of nothing and has nothing to hide.
4. The security holders of the trust can better appraise the trust investment policies and attune the rest of their investment procedure accordingly.
Among the disadvantages of portfolio publication are these: —
1. The results of the costly investment research paid for by the security holders of the trust are revealed to all, and an outsider by following the list can get the same benefits free of charge.
2. Where a trust is either selling or buying a security with a limited market, that market can be seriously interfered with to the detriment of the trust.
3. Investors may be misled. An investment that is good for a trust may not be good for an individual, particularly when the individual does not know and cannot follow the risks and hazards involved.
4. Publication of a list can seriously hamper the managers in their investment research.
Generally speaking, I should say that for trusts pursuing a very wide diversification the publication of their lists is advisable; whereas for that type which tends more to concentration and the selection of a few outstanding issues it is inadvisable. The best English practices have tended away from the publication of holdings.
Every trust should publish complete balance sheets and income accounts. The balance sheets, of course, should reveal all liabilities, contingent or otherwise; securities should be carried at cost, but their present market value should be clearly revealed. Such a policy permits anyone to determine exactly the liquidating value which is essential in a determination of the value of the various securities. The income account should be detailed and reveal exactly from where the income was derived. It is essential that interest and dividends received should be clearly separated from profits from sales. Similarly, the expense account should be broken down, showing how much is paid in salaries and other overhead expenses. The compensation of management should be segregated.
If the investment trusts of the country pursue this policy of complete information, bad practices, simply by revelation, will be eliminated.
In pointing out some of the present abuses of the investment-trust movement, I have indicated by inference rather than directly what can be considered sound and constructive practice. It only remains briefly to suggest what can and has been accomplished in this field when these dangers and abuses are avoided. Without enlarging on the various possible benefits accruing to investors in this movement, I should merely like again to say that far and away the most important contribution that the investment trust can make is to supply honest, constant, expert, and unbiased management, and that if it pursues too extensive diversification it indicates that it will not or cannot supply that management. For investors to pay a heavy loading charge, in the form of management charges and sales commissions, to the managers and promoters of a ‘fixed trust,’ who by its very charter are restricted from using any judgment whatsoever, is in my opinion ridiculous and unjustifiable.
I am often asked what will happen to the investment trusts during a period of declining security prices. In my opinion it is during that period that the real value of the investment-trust movement can be demonstrated. The investment-trust manager should be a financial expert similar in his profession to the doctor of medicine. When we most need a medical doctor is when we are sick. Equally it should be, and I believe is, true that when the investing public most needs expert assistance is during a period of falling security prices. Almost anyone can make money during a period of rising prices, but it will take real skill to curtail losses when things are moving in the opposite direction. I should not go so far as to say that the well-run trusts will not lose money during a period of deflation; but certainly they should, and I believe will, lose less money than the average investor. With conservative capitalization, sound policies, and able management, the investment trusts will make more money than the average investor in good times and lose less in poor times. Such a performance not only justifies but ensures their existence and growth.
- ‘Some Notes on Investment Trusts,’ by J. Edward Meeker↩