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By Jason Zweig | 3:43 pm ET Apr. 24, 2015
This weekend’s “Intelligent Investor” column looks at why more mutual funds don’t close to new investors.
That question is a reminder of why the advent of the modern mutual fund, in 1924, was one of the most important innovations in the history of the money-management business. That year, a broker in Boston named Edward Leffler, a former traveling salesman who had peddled aluminum pots and pans door-to-door after World War I, became fed up with the fact that investors who wanted to diversify had to buy an “investment trust,” or closed-end fund.
Investment trusts pooled many holdings into a single company that issued stock (and often debt) that traded on an exchange, often at a price that deviated from the value of the underlying holdings. The trust manager could raise additional capital only by going to an investment bank and issuing another stock or debt offering. An investor in the trust could sell only by asking a broker to find another buyer.
Leffler came up with the idea of a portfolio that would enable investors to “present their shares and receive liquidating values at any time”–the first known mutual fund, Massachusetts Investors Trust, a fund that still exists today.
Leffler’s invention of the open-end fund enabled the investors in professionally managed portfolios to get their money back any time they wanted it. It also enabled the fund managers to raise money continuously, if they chose to do so.
On the plus side, Leffler created a $16 trillion industry that helped put investing within just about everyone’s reach.
On the minus side, he created a monster. At heart, an open-end mutual fund is like the proverbial shark that must keep swimming forward or die.
On average, according to the Investment Company Institute, the mutual-fund trade group, investors redeem (or cash out) a fifth to a quarter of their assets in stock funds annually. In 2013 alone, investors redeemed $1.49 trillion from stock funds. Thanks to Leffler’s idea that investors should be able to get their money back from the fund company on demand, funds aren’t the lockboxes that investment trusts were. Unless those redemptions are offset by new purchases, mutual funds will shrivel away over time.
An amazing historical detail: The original bill that became the Investment Company Act of 1940, the federal law that governs mutual funds, proposed that funds should have to stop selling new shares once they reached $150 million in total assets (about $2.5 billion in today’s dollars).
Alfred Jaretzki, a securities lawyer who helped draft the law, later wrote that the limit had been proposed out of concerns “that too large an aggregation of capital could not be efficiently managed.”
Because of “the ability to sell new shares,” a mutual fund “has every incentive to promote sales,” noted Jaretzki. “Under these circumstances, and with keen competition between companies in the sale of their shares, it was natural that some questionable practices should have developed.”
The mutual-fund structure creates relentless pressure to grow–and discourages most companies from closing their funds even when markets overheat. When markets turn cold, closings become all but extinct.
In the 1980s and 1990s, some funds took the honorable step of closing to new investors when the managers felt too much money was coming in too fast, thereby helping to protect investors from buying at a market peak.
Now, however, money is bleeding out of actively-managed funds by the billions and fleeing to index funds. “That’s making a lot of companies nervous,” says David Snowball, editor of the Mutual Fund Observer website. “They worry that if they close the door now they may never be able to recover the money they’ve cut off.”
Meanwhile, exchange-traded funds almost never close to new investors. Fewer than 15 out of 1,687 ETFs are closed, says Dave Nadig, director of ETFs at FactSet. Closing to new investors “is super-difficult to do with an ETF,” he says. “You essentially break the product,” since the ability to issue new shares continuously is what keeps the price of an ETF trading in line with the value of its underlying holdings.
Now more than ever, investors are on their own.
Source: WSJ.com, Total Return blog