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protect against cyclical market declines. Diversification is
tied to management by the fact that it must be informed
and intelligent, not merely wide; it must be managed
rather than random. Most funds do use sound judgment
in diversifying their portfolios, and the criticism that the
funds merely “buy the averages” is seen as invalid, since
a survey by the writer of twenty funds indicated that each
had an average of but eight of the thirty widely-known
stocks comprising the Dow-Jones Industrial Average. The
fallacy of merely wide diversification is clearly indicated
by the stock market crash of 1929. Although closed-end
leverage companies averaged 87 issues in their portfolios,
and closed-end non-leverage companies averaged 60.2
issues, their capital decline was far more severe than that
of the open-end companies, which averaged only 46.8
issues. 10 The latter were virtually required to buy sound,
seasoned, marketable issues, primarily because they had
to be able to liquidate parts of their portfolios on demand
for redemptions by shareholders.
A few examples of why the individual needs diversification
may be made. First, he cannot properly invest in a
single stock without risk, as shown by the following examples
[in Figure 1] of “blue-chip” stocks which declined in
value in 1949, a year when the averages rose about 10%.
Even over longer periods, a single investment offers a
very great risk. In the 1939–1949 period, when the Standard
& Poor 90-Stock Average rose 110% (assuming all dividends
reinvested), [the major] issues in [Figure 2] declined.
With the indication that selection of individual securities
is at best an extremely risky proposition, it seems pertinent
to indicate the requirements for diversification in the fund
portfolio. First, the Investment Company Act requires that
at least 75 percentum of the value of its total assets
is represented by cash and cash items, government
securities, securities of other investment companies,
and other securities limited in respect of any
one issuer to an amount not greater in value than
5 percentum of the value of the total assets of such
management company and to not more than 10
percentum of the outstanding voting securities of
such issuer. 11
Moreover, the investment company is not allowed to
change its basic policy statement (i.e., from a diversified
to a non-diversified company) without the consent of a
majority of its stockholders.
In the second place, many funds impose upon themselves
greater restrictions as to the amount and quality of
diversification through restrictions in their charters. The
following examples are typical:
1. To hold no more than 10% of any company’s stock.
2. To invest no more than 5% of assets in any company.
(These two restrictions in effect make the government
requirements effective for the entire portfolio.)
3. To limit borrowing to 10% of assets.
4. To limit underwriting to 5% of assets.
5. To invest not more than 2% of assets in securities
Figure 1
Figure 2
Leading Issues Which Declined In Value In 1949
Stock
Source: Wiesenberger, op. cit., p. 162
Issues Which Declined In The 1939-1949 Decade
Percentage Decline
In Market Value
Air Reduction -65% -38%
International Nickel -50% -13%
NY Central Railroad -46% -18%
United Aircraft -38% +25%
Allis Chalmers -31% +4%
Continental Can -15% +21%
Sources: Wellington Fund sales material; computations by the author
Decline
American Telephone & Telegraph -3 3 ⁄4
Electric Storage Battery -9 3 ⁄4
Gulf Oil Co. -4 5 ⁄8
Standard Oil of N. J. -5 3 ⁄8
Loss Including
Dividends Paid
of an issuer that has been in operation for less than
three years.
6. Not to invest in securities of other investment trusts.
7. Not to hold more than 5% of assets in securities not
listed on the New York Stock Exchange or on the overthe-counter
markets.
A few examples of diversification in various investment
companies [in Figures 3 and 4] indicate how wide it is.
Naturally, the investor has to pay a price for diversification.
In the open end company it is the load, or sales
charge, on the purchase of each share. 12 There has been
much criticism of the large size of the load, which usually
runs from 6% to 9% of the net asset value per share,
depending on the fund. Although, strictly speaking, the
load is the cost of distribution, since the fund itself never
receives any part of it, it may be considered as the cost of
diversification for two reasons: first, because the test of
cost is the value (i.e., the portfolio shares) obtained for
a price, and secondly, because the load is a commission
paid in buying an investment company share, just as a
brokerage commission must be paid in the purchase of
shares of listed stock, of which the portfolio is composed.
Although it is more favorable to compare the load with
any dealer commission—since both are the costs of
bringing the service to the consumer—it seems closer to
reality to compare it with the costs incurred in actually
duplicating the purchase of the investments in the portfolio
which the investment company share represents.
The funds claim that, for the individual, commissions
and other buying and selling costs in obtaining diversification
would exceed the cost of the mutual fund shares.
To buy but one share of each of the securities in the Dowwww.journalofindexes.com
March / April 2012 13