Investing in Investment Funds

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.† 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 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.† 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 “capitalgains 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 of security outstanding. Anew 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 closedend, load versus no-load?