Every Sunday, ipc placed a 'Help Wanted' advertisement in the
New York Times,
and this usually brought sixty or more aspirant salesmen around to the office on Monday morning. Walter Benedick would pack them into a lecture room and give them an introductory dissertation on mutual funds, which carried an invitation to come back for a two-week training course. Usually, something like half of them would return for the course - and soon the intake began to speed up. Nine months after starting operations ipc had a sales force of nearly 1,500 people, with Walter looking after the recruitment and training and Ruth handling the administration.
One of the first stars of the sales force was Gabriel ('Gabe') Gladstone, who was equally celebrated for the volume of his sales and the flamboyance of his character. 'Gabe was a real scatterbrain,' said Walter Benedick. Richard Roberts recalled that Gabe used to visit a psychiatrist - which seemed very impressive to young men like Roberts in the Fifties. Towards the end of 1953, Gladstone introduced a friend of his from Brooklyn College and Three Arrow days: a quiet-spoken young man named Bernard Cornfeld. The Benedicks had not met him before, although Walter seemed to remember the name as having belonged to a group from the Socialist League for Industrial Democracy which spent time at the camp. Benedick agreed to see Gabe's recruit in a private session, rather than the regular Monday lecture.
'Bernie had never had anything to do with mutual funds before,' recalls Walter Benedick. 'He seemed a bit reluctant to have anything to do with the company at first. But he went to a course in the company and my impression is that he was a very good student. He was handicapped because he didn't have any money… On one occasion, he asked me to lend him $80. I still have the receipt. He paid me back - he was the sort of boy you could trust.'
The idea to which Walter Benedick introduced Bernard Cornfeld was older than most mutual fund salesmen of the time realized. The device of forming a company whose business would consist in collecting money from the public and investing it in other companies - light bulb companies, steel companies, or what have you - can be traced back to Britain in the late 1860s. The most dexterous early exponent was a Scottish textile executive named Robert Fleming, grandfather of the man who invented James Bond.
Since its inception, the idea has been shuttled back and forth across the Atlantic. Its most consistent attraction has always been the claim that by putting up a relatively small sum, an investor can participate in the advantages of a large, diversified and professionally managed block of investments. Tins has usually diverted attention from a number of important subtleties and problems.
The basic investment company idea has proliferated into a confusing variety of different types, but the vital distinction is that between the
closed-end
type, and the
open-end
type.
Examples of both existed in the Twenties, but in those days the closed-ends were much the more fashionable. In the more recent boom, the fashion was reversed. The difference owes something to the historical effect of the earlier boom upon the latter, and something to the social changes that took place between the two eras.
It is a question of attitudes to liquidity. The essence of a closed-end investment company is that it operates with a finite quantity of capital: therefore, when you put your money into it you receive in exchange securities not essentially different from those you would get if you put your money directly into a company making light bulbs. Your money has been locked up as part of the capital of the company, and can be turned back into cash only by selling your securities to someone else. It requires, in fact, a considerable degree of financial sophistication: the investor needs to be able to cope with some of the complexities of operating on the stock exchange.
In 1924, the first American investment concern was started which did not use a finite sum of capital, raised in a single operation - but instead, proposed to create and sell new shares in itself on a continuous basis. This was the Massachussetts Investment Trust, which was able to offer as a result of its originality the classic open-end advantage that the company itself would always buy back its own shares from investors, for cash, on demand.
At the time, it did not occur to the people who put their money into closed-end investment companies that they would ever have any difficulty in selling their shares on the stock exchange. Many of them, probably, could not imagine that they would ever want to sell-so the idea of a company which 'redeemed' its own shares had no particular appeal. Before 1929, people did not anticipate that stock exchange conditions might be such as to reduce their closed-end shares to unsaleable pieces of paper. Such horrors as the decline of Goldman, Sachs Trading Corporation lay in the future.
The securities of this classic closed-end investment corporation were first sold on the New York Stock Exchange at $104 per share, which was reduced by the crash to $1.75 per share. 'After 1929' a subsequent report of the Securities and Exchange Commission
1
noted drily, 'closed-ends lost much of their former favour with investors.'
Falls like that of Goldman, Sachs Trading Corporation were not isolated events. By the end of 1929, 'professional expertise' was thoroughly discredited. The stock exchange prices which had been allowed to climb far too high now fell, as a consequence, much too far. At the end of the year, the total saleable value on the stock exchange of
all
shares in closed-end investment companies was just 35% below the actual value of the assets that the companies owned. Anyone therefore who had to sell would lose more than a third of the value of the investments that had been made with his money.
There are without doubt more pure intellectuals in finance than in any other occupation - if it is fair to call an intellectual one who conceives of large, abstract principles and whose delight is then to observe the working out of those principles in actual experiments. Nothing has excited the attention of financial intellectuals more consistently than the principle of leverage. Variations upon the theme of leverage, and associated mechanisms for putting other people's money to work on one's own behalf, run through the whole of this story.
Non-expert heads are inclined to swim when considering the applications of leverage, but the process can be grasped by anyone who understands the operations of A. J. Liebling's Telephone Booth Indians. According to Liebling, a destitute Telephone Booth Indian can always restore his situation with the aid of a telephone, an up-country phone book, and a list of
1
Public Policy Implications of Investment Company Growth, December 2, 1966, page 43.
horses in tomorrow's race meeting. The Indian telephones a number, say Mr Joe Brown's, at random.
The Indian, before Mr Brown can speak, thanks 'good old Joe' effusively, for the great favour Joe did for him last time they met. It was so great a favour that he is calling now to pass on a hot tip… The Indian gives the name of the first horse on tomorrow's list. It is, he says, a certainty. No thanks are required, but if Joe does want to do anything - well, just put on five bucks extra and send the winnings to the following address. The Indian rings off, leaving a puzzled, but hopefully, acquisitive citizen at the other end.
He then goes through the whole field in the same way, and having done so starts again. He may tip each horse to five, even ten, 'old friends'. Some of them will assume that it is the
Indian
who is making a mistake, and will follow up tips with bets. A diligent Indian should thus be able to get enough money to work - none of it his own - to cover the whole field. In that case, one 'investor' at least must win, and will thus be delighted with his good fortune. He will then send the winnings or five dollars to the address given by the Indian: not out of gratitude, but on the theory that this will make another such 'error' more likely, with profitable results to himself.
Neither the crusty and respectable firms of Wall Street and the City of London, nor IOS itself, would ever behave in so gross a manner as the Telephone Booth Indians. But all investment concerns, in greater or lesser degree, rely upon a similar basic idea: getting other people to do something with their money which, hopefully, will benefit them - but if it does, and there are enough of them, will benefit you even more.
What the smarter citizens realized in the Twenties was the potential for leverage arising out of the fact that most companies have two classes of capital. One class - fixed interest securities, such as bonds or debentures - assures the investor of a fixed return on his money. The other class - equity capital -offers him a share of what profit is left over after fixed interest has been paid. In hard times, there can be little or nothing left over for the equity owners, while the holders of fixed interest securities continue to get their return. But in good times, the venturesome equity investors do very much better.
The ratio between a company's fixed interest and equity capital can be adjusted as finely as the gearbox on a Maserati. The higher the proportion of fixed interest capital, the more dramatically the profits accumulate for each equity share. The ratios used by the closed-end investment companies of the Twenties were high in themselves. But a refinement was introduced which multiplied even more dramatically the concentration of the underlying profits for the benefit of a knowing minority of the investors.
This was the idea of superimposing company upon company in a pyramid of tiers or layers, with a tiny proportion of equity creaming off the richest share of the profits at each tier. The classic example is the Goldman, Sachs Trading Corporation. This was an investment company. It controlled the Shenandoah Investment Corporation, which in turn controlled the Blue Ridge Corporation. Both Shenandoah and Blue Ridge were 'highly-geared', with ratios between fixed interest and equity capital of around 20:i. Shenandoah owned almost all the equity of Blue Ridge; and Goldman, Sachs owned 40 % of the equity of Shenandoah. The effect of this double process of concentration was magical from the point of view of Goldman, Sachs. If the market went up by 50%, it had the effect of making Goldman, Sachs's original stake go up by no less than 1,220%.
This daring structure had only just been finished when the boom broke. No-one therefore could find out how long it would have been possible to go on persuading large numbers of people to go on investing money for small returns, so that a few people could
invest small sums for large returns. What was discovered, as Professor J. K. Galbraith put it in
The Great Crash,
was that the magic of leverage 'was equally dramatic in reverse'.
When the crash stripped the closed-end investment companies of their liquidity, the advantages of the open-end mutual fund idea came sharply into focus. Even during the Depression, the mutual funds found it possible to attract some new investors, while the closed-end companies lost popularity.
In 1944, the total of assets in mutual funds became for the first time larger than those in closed-ends, and the mutual fund business was poised to take advantage of the surge in American industrial earnings over the next few years. And there was something besides the folk memory of 1929 to focus attention upon their virtues. During the Fifties, the disposable incomes of Americans rose by 40%, and this increase was sufficient to create investable surpluses among whole new classes of people. A portrait of the new investor was drawn a little later by the Securities Research Unit of the Wharton School of Finance at the University of Pennsylvania:
'He is a man in his middle to late forties, who is married and has about three dependents. His formal education probably stopped after high school graduation; but there is a fair chance that he has done a small amount of college work. Moreover, he is employed most likely in a capacity involving specialized skills - but somewhat short of professional training. His annual income falls in the $5,000 to $10,000 range.'
1
Such people wanted to put their money to use, but they could not handle or afford stock market transactions. They therefore required the simple liquidity of mutual funds.
With history reinforcing its natural advantages over its main rival, the mutual fund concept made astonishing inroads upon the new wealth of the postwar world. Its general impact is expressed in the growth figures quoted earlier in this chapter. The impact upon Bernard Cornfeld was also considerable, and best expressed in a delighted
apergu
which is ascribed to his early days as a fund salesman: 'If you want to make money, don't horse around with steel and light-globes. Work directly with money.' To young men like Gladstone and Cornfeld, it seemed that a field of boundless opportunity was opening up before them.
And so it was. But the open-end mechanism, though capable of collecting enormous amounts of money, has its own uniquely treacherous potentialities. A clue to their nature was given by a mutual fund executive, Richard Cutler of Putnam Management Corporation, in
Barron's
magazine on January 10, 1966. He said:
'The inexorable law of this business is that when assets rise,
1
Report of the Special Study of Securities Markets of the Securities and Exchange Commission, Part 4, page 273.
redemptions rise proportionately, so the more you succeed, the harder you have to sell, just to keep your place on the treadmill.'
It is a little known paradox that when mutual fund organizations are biggest, it may be hardest to extract honest profits from them, and 'Cutler's Law' is part of the reason for this. The problem derives, naturally, from the intrinsic liquidity of the fund. When the value of investments rise there is, to some extent, a desire for customers to benefit from their good fortune by asking the fund to 'redeem' (buy back) their shares, now of increased value. Although 'Cutler's Law' may not be entirely inexorable, it is clear that profit-taking - which cannot so directly affect a closed-end company - can diminish the size of an open-end fund, and undermine its capital strength. And the people who organize a mutual fund take their fees according to the size of the fund.
This problem was taken into account in the grand ancestor of all modern open-end investment companies, the Foreign and Colonial Government Trust, formed in London in 1868 with notables like Lord Eustace Cecil in charge. The Trust had a degree of 'open-ness', in that it undertook to redeem all of its own shares, but the problem of over-speedy liquidation was prevented by having a draw each year to decide which shares should be bought back. This system was eventually prohibited, on the grounds that it was a lottery - although whether it was any more chancy than some of the supposedly open-ended devices which succeeded it a century later is open to question.
Lacking recourse to Lord Eustace's sporting expedient, modern mutual funds must simply sell harder and harder to maintain their size. There is only one sure way to sell more, and that is to pay more to the salesmen. And in order to pay the salesmen more, it is necessary to take more money off the customers.
It is because of the need to sustain large and active forces of salesmen that, when a customer spends f 1,000 to take part in an American mutual fund, no more than $915 is usually invested for him. The remaining 8½% goes in charges. In such a case, the customer cannot get back $1,100 - his own outlay plus 10% until the investments made by the fund have risen by at least the 20% which turns $915 into $1,100.
There are many arguments about the fairness of such arrangements, and about the extent to which the ordinary customer understands them. For the moment, it is enough to say that while none of these prove that the mutual fund concept is unworkable, they do prove that it requires constant regulation and examination.
Young Cornfeld hesitated briefly, before becoming an investment professional. Around the end of 1953, having made a few sales for Investors Planning Corporation, he left New York for Philadelphia, where he worked nine months for the B'nai B'rith cultural and philanthropic organization before returning to ipc as a salesman. This was his period as a social worker, and the evidence does not make it clear whether he distinguished himself or not.