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Figure 5 Figure 6 Investment Company Dividends From Income Selected Funds Over A Five-Year Period Investment Company Capital Gains Disbursements Selected Funds Over A Five-Year Period Fund 1944 1945 1946 1947 1948 Fund 1945 1946 1947 1948 1949 Boston 0.64 0.70 0.71 0.82 0.79 Fidelity 0.71 0.65 0.91 1.07 1.50 MIT 0.96 1.01 1.10 1.23 1.40 Boston — 0.90 1.50 0.50 — Fidelity 1.10 0.83 0.38 — 0.15 MIT 0.50 0.70 — — — Proof of the relative regularity of investment company dividends can be seen from an analysis of three companies [in Figure 5]. Boston Fund, Fidelity Fund, and MIT averaged 4.3% in dividends from income over the past ten years, and never missed a quarterly dividend. There is a virtual legal requirement for the investment company to pay out its income in dividends, for to qualify (and thus gain tax exemptions) under the Internal Revenue Code, Supplement Q, the investment company must distribute as taxable dividends not less than 90% of its net income, exclusive of capital gains, for any taxable year. If it complies with this requirement, it pays no tax on the amount so distributed. This supplement prevents what would otherwise be triple taxation, with the government receiving a tax on corporate earnings, on the dividends from those earnings distributed to investment companies, and on the amount mutual fund stockholders get from their dividends. Capital gains distributions present a problem to the investor as well as to the investment company. They are derived from net profits realized from securities transactions, and generally occur in periods of rising stock prices. For this reason, most companies encourage their reinvestment, and thus hope to prevent this reduction of working assets. The encouragement usually consists in the elimination of the loading charge when dividends are reinvested. Examples of this policy are evident in the Keystone prospectus, which says that capital gains distributions “…may be reinvested in additional shares of the fund at net asset value at the time of reinvestment,” which must be within thirty days after the date of payment. 15 MIT says in its 1950 prospectus that they should “ …be regarded by the shareholders as distributions of principal and not as income …” 16 and that “ …shareholders will be offered the opportunity to reinvest the cash so distributed in shares of the trust at net asset value.” 17 The instability of capital gains dividends can be seen by a survey [in Figure 6] of the three companies whose dividends from income were shown as quite regular. This instability has been in many cases disregarded by the funds in their sales literature, in which dividends were often quoted as the total of securities profit distributions and income distributions, thereby showing an abnormally high rate of return. It is clear that in a declining market, the capital gains portion would certainly decrease if not disappear entirely, so the practice seems misleading to the investor. The SEC Statement of Policy of August 11, 1950 took account of this when it declared that it is “ …misleading…to combine into any one amount distributions from net investment income and distributions from any other source.” 18 One advantage of capital gains dividends that has been exploited in a few cases by specialty funds has been the fact that the investor need only pay capital gains taxes on security profit distributions, thus cutting his tax roughly fifty percent. Growth and speculative funds have therefore been made available to the investor whose taxable position is such that capital gains are more valuable than regular dividend income. Liquidity …the quality of being convertible into cash at a price approximating the value of the investment… Liquidity of shares, or their redeemability by the fund at approximately net asset value, serves a dual advantage for the investor. 19 First, it makes it possible for him to receive the fair value of his share on demand, and second—a corollary of this advantage— the management must be sensitive to his desires and is thus responsible directly to him. Although redeemability is the unique feature of the open-end company, the Investment Company Act of 1940 made it statutory, giving the investor the privilege of redeeming shares at a price approximating net asset value within seven days, except when the New York Stock Exchange is closed under extraordinary conditions or SEC declares an emergency to exist, during which it is impracticable either for the investment company to dispose of its securities or for it to fairly determine the net value of its assets. 20 The redemption feature establishes a continual market for the fund shares. Incidentally, there was no interference with the redeemability right in the market breaks of 1929, 1937, and 1946; and the New York Stock Exchange has been closed only once in the twenty-five years that the mutuals have been in business. In practice, there has never been any appreciable waiting period between the time shares are tendered for redemption and the fund’s payment www.journalofindexes.com March / April 2012 15
of cash to the shareholder. There are two factors which can relieve the company of the necessity of liquidating its portfolio securities to meet a run on redemptions, both of which are provided for in the Investment Company Act. First, section 18(f) allows bank borrowing “ …provided that…there is an asset coverage of at least 300 percentum”; thus the funds may borrow to meet current (and temporary) negative net sales. Second, the issuer is allowed, under section 2(a)(31), to compensate the holder with “approximately his proportionate share of the issuer’s current net assets,” rather than “ …the cash equivalent thereof.” This provision has not been used, however, and some funds limit their redemption payments to cash value alone. In practice, redemptions have proved to be a relatively fixed percentage of total assets, so with greater size, the investment company must increase its sales in order to gain the same amount of net sales [see Figure 7]. During economic crises, sales and distribution efforts have to be increased in order to offset high redemptions by the jittery public. These increased efforts were clearly shown in the 1927–1936 period, when only in two quarters did redemptions exceed sales. Besides the advantages of redeemability per se to the investor, the concept has three very important implications; first, a major portion of the portfolio must be composed of highly seasoned securities of ascertainable market value; the holding of this type of security, the writer submits, is one of the reasons the open-end fund survived the depression so much better than its closed-end counterpart. Second, the redeemability feature prevents the use of senior securities, since redemptions could destroy the equity behind such securities. The investor, therefore, is never in danger of having his interests subordinated by the use of preferential capital. 21 Third, the threat of withdrawal means that management must continually provide satisfactory performance, at the risk of having to liquidate its portfolio and go out of business. Hedge Against Inflation …to safeguard the purchasing power of capital by investing it in things which advance, in both price and yield, as the cost-of-living advances… It seems a basic economic truth that the most likely investment to appreciate in value and in return as the purchasing power of the dollar falls is an investment in common stocks. Although the correlation between stock value and price level is by no means perfect, common stocks offer the investor far greater purchasing power protection than do bonds or savings accounts. It is logical to assume, therefore, that the investment companies, varying with the market and having portfolios composed largely of common stocks, will also provide the investor with a “hedge” against the rising prices of consumer goods. Figure 7 Figure 8 Relationship Of Fund Redemptions To Total Fund Assets Year Changes In National Income, 1937 And 1948 All Figures but per capita income in $ billions National Income Percent Per Capita Income Year Personal Income Taxes Percent 1941 11.2 1946 10.9 1942 6.2 1947 6.2 1943 7.8 1948 8.5 1944 7.9 1949 5.4 1945 8.5 1950 11.1 Sources: National Association of Investment Companies figures; computations by author Disposable Income 1937 73.6 552 73.9 2.9 71.0 1948 226.2 1,302 211.9 21.9 190.0 Real 1948* 144.3 833 135.0 13.4 121.0 * in 1937 dollars Sources: Statistical Abstract of the United States: 1950; “Real” computations by the author Professor Sumner Slichter, professor of economics at Harvard University, has said that an investment counsel who advises his client to place his funds in savings banks, postal savings, or government securities “is assuming a very heavy responsibility,” asserting that properly selected stocks should prove to be a reasonable protection against the rising cost of living. 22 In his opinion, unless the government issues savings bonds payable in a fixed amount of purchasing power rather than in fixed dollar amounts, the well-managed mutual fund is the best answer to the problem of inflation for the small investor. Certainly the mutual fund offers a better hedge against purchasing power decline than would bank deposits or bonds, which are taxed in dollar rates. The value of common stocks, in a survey by Emerson W. Axe, was shown to yield an average of $2.80 for each dollar invested during twenty-year periods from 1858 to 1948, under a plan of dollar-cost-averaging which required the investment of $1,000 each quarter in a common stock average. 23 This procedure enables the investor to spread his investment over time. In the worst period (1918–1938), the amount realized was $164,181 on an initial investment of $80,951 (plus reinvested dividends of $56,112). The best was 1908- 1928, after which $347,474 was realized from an initial investment of $81,015 and reinvested dividends of $87,896. These amounts are comparable with $99,594, the realized amount from $4,000 invested annually for twenty years in a savings bank, at current rates. Some funds specifically attempt to procure common stocks which will provide a hedge against infla- 16 March / April 2012
Page 1 and 2: Plus an excerpt from Bogle’s fort
Page 3 and 4: Contributors Rolf Agather Rolf Agat
Page 5 and 6: Jim Wiandt Editor jwiandt@indexuniv
Page 7 and 8: FREE subscRiption oFFER! The Journa
Page 9 and 10: Editor’s Note Tipping Our Hats Ji
Page 11 and 12: The Economic Role Of The Investment
Page 13 and 14: stated so that the investor can car
Page 15: Jones 30-Stock average would cost $
Page 19 and 20: een increased in recent years due t
Page 21 and 22: A Fireside Chat The Bogle Interview
Page 23 and 24: tem. I’m worried about Citizens U
Page 25 and 26: The Bogle Impact: A Roundtable Coll
Page 27 and 28: ing him. That will be Jack’s lega
Page 29 and 30: JoI: What do you think John Bogle
Page 31 and 32: Bogle’s Corner Ideas Vs. Implemen
Page 33 and 34: Lessons Learned From SPIVA 10 obser
Page 35 and 36: Figure 3a % Of Funds With Top-Quart
Page 37 and 38: The Case For Indexing Revisiting th
Page 39 and 40: Figure 2 Annualized Excess Returns
Page 41 and 42: Figure 5 Inverse Relationship Betwe
Page 43 and 44: Figure 8 Shorter Time Periods And M
Page 45 and 46: Figure 10 Excess Returns Help Quant
Page 47 and 48: Indexes In Perspective The Index In
Page 49 and 50: Talking Indexes Keeping It Simple A
Page 51 and 52: News Index Providers To Form Trade
Page 53 and 54: News the pair would work on develop
Page 55 and 56: News Turkey, EEML mimics an index t
Page 57 and 58: Russell continued from page 47 nati
Page 59 and 60: Index Funds 58 March / April 2012
Page 61 and 62: Dow Jones U.S. Industry Review Perf
Page 63 and 64: Dash continued from page 35 of acti
Page 65 and 66: Test Your Skills A True Industry Va
Page 67 and 68:
VOO Vanguard S&P 500 ETF For an exp
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