INVESTMENT COMPANIES. As defined by the 1940 Investment Company Act, investment companies are publicly held corporations or trusts "in the business of investing, reinvesting, owning, holding, or trading in securities." In the form of mutual (or open-end) funds, they constituted the most spectacular growth industry on Wall Street in the late twentieth century, which is all the more remarkable in light of the role that (closed-end) investment companies played in the speculative mania leading up to the October 1929 stock market crash.
Early Developments and Abuses
The first investment companies in the United States developed out of public utility holding companies and were organized to gain control of corporations. Public utility holding companies issued bonds and used the proceeds to purchase controlling shares of utility companies. In 1905, the Electric Bond and Share Company (EB&S) became the most prominent investment company of the pre– World War I period by taking the next step and issuing preferred stock in order to use the proceeds to purchase controlling shares of utilities. EB&S was organized by General Electric (GE). It purchased controlling shares of utilities because they were, or would become, major purchasers of GE equipment.
Although public utility holding companies remained a major factor in the investment company movement of the 1920s, a structural change in the source of new savings available for investment purposes ensured an increasingly prominent role for the investment companies organized by investment banks. Prior to World War I, firms like J. P. Morgan and Company and Kuhn, Loeb and Company dominated investment banking because of their access to British and German savings, respectively. But after the war, which destroyed Britain and Germany as sources of new savings, dominance shifted to investment banks like Dillon, Read and Company and Goldman, Sachs and Company because of their success in organizing investment companies that served as magnets for the savings of salaried workers and small business owners in the United States. The keys to their success were large sales forces dependent on commissions for their incomes, installment payment plans for customers, and mass advertising campaigns designed to persuade millions of Americans that, by purchasing shares of investment companies, they could gain the same diversification, liquidity, and continuous supervision of their investments enjoyed by the wealthy.
This message proved illusory insofar as the closed-end investment companies of the 1920s were concerned. Closed-end investment companies assumed no responsibility for issuing new shares or redeeming outstanding shares at their net asset value. As the speculative mania of the 1920s gathered momentum, this lack of responsibility, combined with the absence of government regulation and supervision, created an irresistible temptation for the investment banks that sponsored investment companies to make profits at the expense of the investors in them.
Such profits came from the fact that the investment companies placed deposits with and loaned money to the investment banks that sponsored them, served as depositories for the stocks they underwrote, issued shares to the investment banks' partners for a fraction of their market price, and paid underwriting fees and in some cases salaries to the investment banks' partners for sitting on the boards of directors of the investment companies.
For example, the most prominent investment company in the 1920s was the United States and Foreign Securities Company (US&FS). It was organized in 1924 by Dillon, Read and Company, which raised $25 million from the public by issuing 250,000 shares of US&FS common stock as attachments to 250,000 shares of 6 percent first preferred stock, for $100 a bundle. Dillon, Read and Company maintained control by putting $5 million into US&FS in exchange for 750,000 shares of common stock attached to 50,000 shares of 6 percent second preferred stock, for $100 a bundle. Dillon, Read partners also paid themselves a $339,000 underwriting fee and gave themselves common stock in US&FS, which traded as high as $73 per share, for about 13 cents per share.
As remarkable as these profits were, they were nothing compared with the profits Dillon, Read and Company made in 1928 by pyramiding a second investment company, the United States and International Securities Corporation (US&IS), onto US&FS. Dillon, Read raised another $50 million from the public by issuing 500,000 shares of US&IS common stock as attachments to 500,000 shares of 5 percent first preferred stock, for $100 a bundle. It maintained control—and created the pyramid—by having US&FS spend $10 million on 2 million shares of US&IS common stock that were attached to 100,000 shares of 5 percent second preferred stock, for $100 a bundle. For the time and trouble of thus leveraging its initial investment of $5 million in US&FS into control of $75 million of the public's savings, Dillon, Read partners gave themselves a $1 million underwriting fee and US&IS stock for pennies per share.
This kind of pyramiding of investment companies by investment banks accounts for the spectacular growth in the number of investment companies in the 1920s, from about 40 in 1921 to about 700 in 1929. Most of the investment companies were organized in the 1926–1929 period, with over 250 organized in 1929 alone. Indeed, nearly one-third of all new corporate financings in the months leading up to the crash were stock in investment companies.
The largest pyramid, which included four of the fourteen investment companies with total assets of more than $100 million in 1929, was started in December 1928 by Goldman, Sachs and Company, when it issued stock in the Goldman Sachs Trading Corporation (GST). GST merged with the Financial and Industrial Securities Corporation, which became a major depository for GST stock. GST then joined with the Central States Electric Corporation (CSE) to organize the Shenandoah Corporation, which organized the Blue Ridge Company as a major depository for CSE stock. CSE held controlling shares of American Cities Power and Light Company, which held controlling shares of Chain Stores, Inc., which held controlling shares of a company that was actually in business, Metropolitan Chain Stores. However, the profits of Metropolitan Chain Stores were insufficient to pay dividends on all the stock issued by the six investment companies and one public utility holding company pyramided onto it, and by 1932, GST stock, issued to about 40,000 investors for $104 a share, was trading for $1.75 a share.
The collapse of the pyramid of investment companies built by Goldman, Sachs and Company illustrates the larger trend of the investment company movement in the early 1930s, whereby the total market value of investment companies dropped from a peak of about $8 billion immediately prior to the October 1929 crash to less than $2 billion in 1932.
Reforms and New Trends
The passage of the 1933 Securities Act, the 1934 Securities Exchange Act, the 1935 Public Utility Holding Company Act, and the 1940 Investment Company Act (amended in 1970) created rules and enforcement mechanisms to prevent the practices of the investment banks in organizing investment companies in the 1920s. Most importantly, new laws required that directors of the investment companies be independent of the sponsoring investment banks, and thus free of the conflict of interests that allowed investment banks to profit at the expense of the shareholders in the investment companies they sponsor.
Nonetheless, closed-end investment companies never recovered from the October 1929 stock market crash. What has taken their place, and become the principal means by which salaried workers and small business owners save, are open-end investment companies, or mutual funds. Mutual funds continuously issue new shares and stand ready to redeem outstanding shares at their net asset value. Even in 1929 mutual funds constituted over 500 of the 700 investment companies; they were just dwarfed by the publicity, size, and seemingly easy money to be made by purchasing the shares of closed-end investment companies. At the time of the passage of the 1940 Investment Company Act, there were only sixty-eight mutual funds left, with about $400 million in assets. But after World War II, they began to grow. Gross sales of new shares in them was more than $10 billion between 1946 and 1958, by which time there were 453 investment companies (238 mutual funds) with total assets of about $17 billion. By 1960, mutual funds alone had $17 billion in total assets, and by 1970 there were 361 mutual funds with assets of $47.6 billion. Meanwhile, closed-end investment companies were marginalized, with only $4 billion in assets.
In the 1970s, money market funds became a significant new trend in the investment company movement. It was during the 1970s that the government removed the interest rate ceilings on bank deposits that had been in effect since the 1930s, starting with the ceilings on large-denomination time deposits. Money market funds were attractive to small investors because, by pooling their savings, the money market funds could obtain the higher returns on the large-denomination time deposits. By also allowing shareholders to write checks, money market funds became an attractive alternative to placing savings with commercial banks, savings and loans, credit unions, and mutual savings banks.
The first data available on money market funds is for 1974. They constituted $1.7 billion of the $35.8 billion of total assets in mutual funds. (There was a severe downturn in the market in 1974–1975.) By 1979, money market funds were up to $45.5 billion, practically catching up with all other mutual funds at $49 billion, for total mutual fund assets of $94.5 billion. In 1983 they surpassed all other mutual funds in total assets ($179.3 billion versus $113.6 billion, for a total of $292.9 billion).
In the mid-1980s another trend began in the investment company movement. Salaried workers and small business owners stopped making new investments in the stock market except through mutual funds. Whereas net purchases of equities by households outside mutual funds has been negative since the mid-1980s, their purchases of equities through mutual funds grew from $5 billion in 1984 to a peak of $218 billion in 1996, but was still a hefty $159 billion in 1999.
On account of the growth of equity funds, in 1985 mutual funds other than money market funds were once again larger than the money market funds, at $251.7 billion and $243.8 billion, respectively, for a total of $495.5 billion. In 1993, equity funds became larger in value than money market funds, at $740.7 billion and $565.3 billion, respectively. In 1999, the total assets of 7,791 mutual funds reached about $6.8 trillion. Equity and money market funds accounted for a bit more than $4 trillion and $1.6 trillion of the total, respectively.
Carossa, Vincent P. Investment Banking in America: A History. Cambridge, Mass.: Harvard University Press, 1970.
Investment Company Institute. Mutual Fund Fact Book. Washington, D.C.: Investment Company Institute, 2000.