Reporting to the IIT shareholders at the end of 1962, Buhl was at rather a loss to explain the depressing condition of Wall Street. 'One fact seems certain,' he said, '… the companies behind these shares did not suffer special declines; profits were generally as high in 1962 as anticipated.' Minitone Electronics had not made any profits and there was no firm reason, when IIT bought Minitone shares, to think that it would. So perhaps that company was not included in Buhl's reflection.
At the end of 1961, IIT had about $3.4 million worth of investments of which about $100,000 was in Cowett's 'babies'. A not inconsiderable 2.9% of the fund was thus invested in concerns associated with a director of IOS. Just how much IIT lost on Cowett's companies could only be determined by a detailed analysis of IIT's transactions in 1961 and 1962. Cowett himself says the loss was of the order of $70,000 to $100,000.
The disaster which struck Cowett's companies, and glamour stocks generally, sparked off panic measures at IOS: a reaction that was to be duplicated eight years later. The newly appointed Buhl decided that the best thing to do was to liquidate large parts of the IIT investments. The portfolio that Dr Hugi has assembled contained a great number of small parcels of different securities - too many, by modern American standards, for efficient handling of the investments. Nevertheless the wholesale selling which Buhl embarked on inevitably meant that a number of better quality stocks were sold at almost rock bottom prices. By the end of 1962 the new IIT management had lost $1,133,000 on sales of shares, a staggering 33% of the securities held at the start of the year. The shrinkage in value was covered only by the gallant efforts of the far-flung salesmen, who brought in enough new cash for the fund to increase slightly in size during the year.
The price of IIT shares continued to fall until October 1962 when it had sunk to $3.53. This coincided with the launching of the Fund of Funds and the IOS Investment Programme, under which IIT was from then on sold. Later IOS concealed the early disaster of IIT by calculating all growth records from its nadir in October 1962; this made its performance look reasonably respectable. In reality IIT did not regain its December 1960 launching price of $5 until early 1965. IOS justified this deception by saying that IIT only came under IOS’s management in the autumn of 1962. This can now be seen to be untrue, IOS had full control of the management company of IIT from its inception and it played a crucial and fateful role in the selection of some of its investments. Even the replacement of the 'outside investment adviser,' Dr Hugi, took place in May and not October. Cowett, at least, is now frank about it: when we asked him why IOS always used October 1962 as the starting point of IIT he answered, 'It looked better; that's why.'
Cornfeld's behaviour towards Cowett in 1962 was in many respects admirable. He rescued an undoubtedly able friend and colleague from the consequences of folly, and at considerable cost to himself. It was, if you like, Cornfeld the social worker, always ready to help a man who had stumbled in his career.
But it cannot be left just like that. Cornfeld declines to say exactly how much he knew of the details of Cowett's activities - but he was obviously in a position to know everything. Yet Cowett was retained as chief legal adviser of IOS. After a relatively brief absence, he was readmitted to the board of IOS -and within five years Cornfeld was ready to entrust him with control over the investments of a million clients around the world.
Chapter Seven
The Birth of a Superfund
In which we examine the Fund of Funds, which is really a Gimmick of Gimmicks. How it worked to the advantage of its inventors, Ed and Bernie, and to the disadvantage of its investors.
Bernard Cornfeld's niche in financial history is secured, if by nothing else, by his promotion of the Fund of Funds, the classic investment vehicle of the offshore decade. There has been much dispute about who first conceived the idea of a mutual fund whose business would consist of investing in other mutual funds. Nobody has disputed that it was the most potent idea of all that came out of IOS.
The Fund of Funds was launched in the autumn of 1962, and according to Ed Cowett the idea was born when he and Cornfeld were riding a sleigh together on a winter night in Canada. They were tossing new investment devices to and fro -but Cowett insists that the basic inspiration was Bernie's. Certainly it was Cornfeld who breathed life into it by adding that simple Biblical name. Robert Nagler, a Dreyfus vice-president who had been hired by IOS, arrived in Geneva when the idea was still being worked out, but remained as yet unnamed. One day, Cornfeld walked into Nagler's office at 119 Rue de Lausanne (IOS had by now taken over the whole building). 'How about "Fund of Funds"?' Cornfeld asked. Nagler could only say 'Great.'
Even by IOS standards, the salesman's rationale for the Fund of Funds was an unusually owlish piece of nonsense - one of those things that sounds impressive until you really think it through. Mutual funds, and all investment concerns, are sold
on the proposition that the ordinary man needs investment advisers to make his choices for him. The Fund of Funds went further and suggested that the ordinary man now needed professionals to choose the professionals who would make the choices. The Fund of Funds would take your money, and invest it in other mutual funds - but only in those whose values were rising most rapidly. Or, if one mutual fund was good, a mutual fund which contained twenty other mutual funds must be twenty times better.
An sec lawyer exploded the Fund of Funds argument succinctly. 'If funds on funds are permitted to proliferate,' he wrote, 'how would an investor decide among the many companies seeking his investment dollar? Would he not need a
fund on funds on funds
to make this decision?'
There was another rationale to the Fund of Funds, which was not trumpeted so loudly. Mutual fund companies, of course, take their profits by charging the customers a management fee. But out of this fee they have to pay for investment analysts and for the organization necessary to buy and sell large quantities of securities. The FOF charged a management fee, but the only 'management' involved was channelling money into one mutual fund rather than another.
This neat impost upon the customers would not have been possible 'onshore'. Indeed, the Fund of Funds was an animal so curiously made that it could only survive in the kindly offshore waters. It was registered in the Province of Ontario, in Canada.
It was set up with two classes of shares, something which American investment companies are specifically prohibited from doing. There were Class A Preference Shares, which were sold in thousands to the public. These carried no voting powers. It also had a class of Common shares, which were not common at all. There were originally only 350 of them, and they were all controlled by IOS. These were the only voting shares, and the result was that Cornfeld and Cowett could do virtually anything they wished with the Fund of Funds.
Originally, its main purpose in life was to invest in mutual funds in the United States, where the mutual funds were most exciting.
American official hostility to the idea of investment companies investing in other investment companies dates from the part played in the 1929 insanity by investment companies which owned securities in other investment companies, in the kind of 'tiers' described in Chapter 3. Until the debut of the Fund of Funds, many Americans thought that the Investment Company Act (1940) had made it illegal in America for one investment company to buy another's shares. But for complex technical reasons, the Act does not do that. It merely says in Section 12(d) 1, that no American-registered investment company can own more than 3% of the shares of any other investment company. The Fund of Funds escaped this limitation simply by residing in Ontario.
When the sec became aware of this arrangement, they pointed out that it could have an effect on stock markets which might be similar to the investment company speculation of 1929. The sec's reservations were not widely shared, certainly not by Bernie's sales force. The Fund of Funds, like IIT, was decorated with good names: Credit Suisse was again Depository of Cash, and Bank H. Albert de Bary of Amsterdam was Custodian of Securities. Montreal Trust, a subsidiary of the Royal Bank of Canada came in as Transfer Agent and Registrar, IOS artwork had improved no end since the early days of IIT, and the Fund of Funds literature acquired a coat of arms; a symbolic bull and bear prancing amid oakleaves.
The Fund of Funds really did take off like a rocket. It was under a million dollars in October 1962: by September the next year it hit $16.65 million. At the end of 1964, after a little over two years operation, it hit $100 million. Nothing like it had been seen before - after all, the Dreyfus Fund had taken nearly six years to go from half a million to a hundred million. The development of the Fund of Funds 'has made it the phenomenon of phenomena', observed an awestruck correspondent of
The Times,
from Geneva.
From the moment the sales force first pushed it out, the proposition looked so bewitching that the customers did not seem to be impressed by the financial disadvantages they suffered from the 'layering' of costs. There were two management fees on the customers' money, one taken by IOS, and the other taken by the mutual funds in which the Fund of Funds invested. The layering effect also applied to sales loads. As we noted in Chapter 3, an expansion-minded mutual fund seller has to chop out a chunk of each customer's money in order to pay off his sales force. Competition for salesmen pushed this up in the mid-Sixties to a top rate of about $8.50 in every $100 for the US trade, and it was only to be expected that IOS, with so many salesmen sincerely wanting to be rich, would charge the top rate.
The customers suffered from the fact that there was another sales load when the Fund of Funds bought us mutual fund shares. True, IOS was able to make bulk purchase arrangements which cut this down to under 1%. But it still came out of the customer's money.
This was bad enough, one might think, but it was only the beginning. After operating on this model for about two and a half years, IOS had a brilliant idea. Why not reorganize things so that they could appropriate all the layers for themselves?
This inspiration produced the first period of radical change in the Fund of Funds - in mid-1965, when IOS was still combing the world for money and had not yet run into any serious trouble over the currency busting activities of its salesmen.
Contrary to the general belief, it was not a prohibition by the Securities and Exchange Commission which prompted Bernie and Ed to modify their original idea. What happened was that the creative minds in Geneva realized that IOS could do even better for itself than taking a fee for channelling the customers' money into funds run by other people. Suppose IOS
itself
controlled the funds into which the money went? IOS would then be able to benefit from two levels of management fees.
This rather turned the original idea on its head, but it opened up great possibilities. There was no intention, or possibility, that IOS could set up orthodox mutual funds in America. But what they could, and did do, was set up
proprietary
funds, each one of which would have only one investor - the Fund of Funds. Such funds would not have to be registered with the sec.
IOS was not only able to benefit from two sets of management fees. The second sales charge, now dressed up as 'brokerage' commission was appropriated by IOS for the onerous duty of transferring the customers' money from the Fund of Funds to the individual proprietary funds!
The great wonder of the Fund of Funds was its plasticity. It transmogrified itself several times, and eventually the only characteristic it retained of the original fund on funds idea was a layering of charges. To show just how changeable, and how misleading, the form of FOF was eventually capable of being it is necessary to leap forward for a moment in time, and to consider some technicalities.
Individuals who trade their own investments on stock markets may wish to make money by wagering on short term movements of prices. To 'sell short' is to bet on a fall: a short seller undertakes, for payment at today's price, to deliver at a future date some set number of shares, which he does not then possess. Assuming that the price of such shares drops before he has to deliver, he can supply himself with enough of them to honour his commitment, while leaving him a profit on the payment he received earlier. If the price rises, he loses his bet.
To buy 'on margin' is essentially to bet on a rise. Brokers at certain times are prepared to give possession of shares on a receipt of cash payment covering only a part of the price. If the value of shares bought goes up, the buyer reaps the same advantage as if he had paid in full. But if they fall, the broker will quickly demand payment of all the original purchase price, and the buyer can easily lose more than he put up in the first place.
Clearly, these activities go beyond the ordinary buying and selling of shares, and are more suitably undertaken with one's own money than with other peoples'. With this in mind, the law in America, Britain and most other financially sophisticated places says that open-end funds may not sell short, or buy on margin. There are also restrictions on the kind of things that an open-end fund can put money into, and the most important restriction is against investment in real estate. This is designed to preserve the liquidity which persuades many people to buy fund shares. Assuming a fund's assets are all listed on the stock exchange, their value can be checked independently every day, and they can be sold rapidly if people wish to make redemptions. Real estate, obviously, has no formal market. It may take a long time to sell, and until sold its value is a matter of opinion. Mutual funds and unit trusts are therefore effectively prohibited from making real estate investments.