Do You Sincerely Want To Be Rich? (15 page)
Read Do You Sincerely Want To Be Rich? Online
Authors: Charles Raw,Bruce Page,Godfrey Hodgson
Tags: #Non Fiction
On May 2, 1968 the prospectus of the Fund of Funds made this reassuring declaration:
investment restrictions
While professional management, by definition, implies the prudent management of other people's money,
Fund, of Funds
management, as a matter of policy, has adopted the following restrictions for the protection of its investors. Among these are that the Fund may not borrow money, purchase any securities on margin, sell securities short, lend any of its assets (except for the purchase of government bonds), or purchase, lease or acquire real estate. (Funds in
The Fund of Funds
portfolio may, depending upon their respective charters, sell short, borrow money or purchase securities on margin, and buy, sell or hold real estate.)
Fund, of Funds
management, as a matter of policy, has adopted the following restrictions for the protection of its investors. Among these are that the Fund may not borrow money, purchase any securities on margin, sell securities short, lend any of its assets (except for the purchase of government bonds), or purchase, lease or acquire real estate. (Funds in
The Fund of Funds
portfolio may, depending upon their respective charters, sell short, borrow money or purchase securities on margin, and buy, sell or hold real estate.)
This would appear to suggest that the IOS fund managers would not indulge in such activities - with the proviso that they cannot guarantee that the fellows in whose companies they invest may not do so from time to time. The truth was exactly the other way about. The actual fact was that the managers who controlled the bulk of the Fund of Fund's assets - were all appointed by IOS and IOS itself devised a method whereby their customers assets could be used in 1968, 1969, and 1970 to borrow money, buy on margin, sell short, to lend fund assets out and to handle real estate.
And the customers' assets were indeed employed in short trading, were lent out to market operators, and were used to buy real estate.
Finally, large segments were used, disastrously, in the most esoteric development of the basic real estate idea, the natural resources business.
The only funds in the Fund of Funds which could
not
undertake any of these uncertain activities were the ones that IOS did not control. This was because FOF still had some investments in perfectly ordinary us mutual funds, such as it started out with.
not
undertake any of these uncertain activities were the ones that IOS did not control. This was because FOF still had some investments in perfectly ordinary us mutual funds, such as it started out with.
The key to the versatility of the Fund of Funds lies in its original constitution, IIT was not a very substantial legal entity, but it did have rules which could not be changed without the permission of the Luxembourg Banking Commission. Fund of Funds was altogether less cramped.
Onshore mutual funds and unit trusts are only allowed to change their structure and objectives slowly, if at all. Certainly they cannot do so simply at the will of the management. As a last resort the investors, apathetic though they may be, hold voting rights over the fund's actions. Through its controlling shareholding IOS could, and did, alter the fund's financial policy at will, often without giving its investors any clear idea what was going on. In the end, the Fund of Funds turned in disastrous directions; it is hard, at any point, to see where its remarkable freedom operated to the benefit of IOS’s customers, rather than to that of IOS itself.
When Cornfeld adopted the 'proprietary' system, he needed to hire managers in America to run his new funds. A consultant named Conrad Taff introduced Bernie to his first team.
This was two young men called Dean Milosis and Carlyle Jones, who had been working for a well-known 'hedge fund' manager named Arthur Jones. The essence of a hedge fund is to operate in short sales, so it was not surprising that when Milosis, Jones and IOS got together to form the York Fund - sole investor, The Fund of Funds - it set out to engage in short sales. Nobody seemed to think it important that the FOF prospectus assured the clients that it was not allowed to make short sales. The next manager they hired was Fred Alger, who came, like Christian Henry Buhl, from a good class Detroit background, and who managed a fund in New York called the Security Equity Fund, which increased in value-per-share fastest of all us funds in 1965. With IOS he set up the Alger Fund, and soon there was a whole battery of special IOS funds while the Fund of Fund's holdings in publicly offered mutual funds began to run down.
Wall Street was in full cry again: the brief distress of 1962 was fading rapidly in the memory, the conglomerate stocks were sizzling, and Adam Smith's 'gunslingers' were beginning to twirl the pearl handled.45's around their fingers… Rather sadly for the customers, IOS was beautifully positioned to take a leading role in the speculative shoot-out.
This gets ahead of our story - but before returning to the narrative, it is worth anticipating the greatest flexibility of FOF. When, in 1967, IOS was forced, under threat of prosecution, to cease making investments in
any
us registered investment company, this was not mentioned in the annual report of the Fund of Funds to its shareholders. However, a new company called FOF Proprietary Funds Ltd appeared in the Fund of Funds list of investments with remarkably little explanation.
any
us registered investment company, this was not mentioned in the annual report of the Fund of Funds to its shareholders. However, a new company called FOF Proprietary Funds Ltd appeared in the Fund of Funds list of investments with remarkably little explanation.
This was another Canadian-registered concern. Now, the sec ban was avoided by turning all of the separate 'funds' into 'sub-accounts' of the Canadian company. Ostensibly, the
new
Canadian company, and its sub-accounts, made investments in America, while in fact the investments were still run by the same bright young managers in New York. Later, we must describe the system devised to make the continued operation legally defensible. The important point for the moment is that IOS now channelled most of the new Fund of Funds money through this new company called FOF Proprietary Funds.
new
Canadian company, and its sub-accounts, made investments in America, while in fact the investments were still run by the same bright young managers in New York. Later, we must describe the system devised to make the continued operation legally defensible. The important point for the moment is that IOS now channelled most of the new Fund of Funds money through this new company called FOF Proprietary Funds.
All these Canadian operations, of course, were simply legal devices: the money continued to be handled in Geneva and New York. But IOS, apparently, saw no reason not to do itself a bit of good through their existence. Originally, the IOS parent company had put up $1 million to create a capital structure for FOF Prop. At the end of 1967, IOS took to itself cash dividends of $2,453,696 on this modest investment. Somehow, large profits were being made when the customers' money passed through FOF Prop.
After this rather fine performance, FOF Prop, became in 1968 a wholly-owned subsidiary of Fund of Funds Ltd. Now, the whole thing had turned into an ordinary investment company. It employed managers, and it now invested not in investment funds, but directly in securities - and, as it turned out, almost anything else that came to hand. It was not a Fund of Funds at all. Yet the continued legal existence of the 'shell' company FOF Prop, not only allowed Bernie and Ed to maintain the appearance that they still had a fund on funds, but it also enabled them to continue to lift another 1% of the customers' money, as it passed, strictly only in the books in Switzerland, from the Fund of Funds to its subsidiary.
These rapid evolutions never caused Bernie and Ed to lose the air of gravity and high purpose which is generated in the best of their printed work. They liked to decorate their prospectuses with elevated quotations, and the 1968 one which contained the assurances about short sales
1
Dreyfus officials had actually drawn up a contractual programme at about this time.
1
Special Study of Securities Markets, sec 1964. Vol 4, page 107.
1
Special Study.
also contained the famous statement of the Prudent Man Rule made by Justice Putnam of the supreme Judicial Court of Massachusetts in 1830:
'All that can be required of a Trustee to invest is that he conduct himself faithfully and exercise a sound discretion. He is to observe how men of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested.'
If there was a light, dry hum to be heard somewhere in Massachusetts in May 1968, it was presumably Mr Justice Putnam revolving in his grave like a high speed gas turbine.
Recalling his first meeting with Jack Dreyfus in New York, Cornfeld gives this account of the exchange: ‘I told Dreyfus, "Yours is the only readable prospectus in the industry. I sell more funds using it than I sell using our own." '
' "Why don't you sell my funds?" Dreyfus asked. I told him, "Because you have no programme." '
1
1
Taken on its own, the Fund of Funds was a device which provided its operators with unusual opportunities for profit and having created FOF, Cornfeld and Cowett fitted it into an operating framework called The IOS Investment Programme -with breathtaking results. It was this combined machinery which produced, from the resources of the customers, the rich and ample fodder on which Bernie's sales force grazed.
It is one of the features of the open end fund business, on both sides of the Atlantic, that although it is supposed to exist
1
Dreyfus officials had actually drawn up a contractual programme at about this time.
for the benefit of smaller investors, its operators make more money the larger the average holding of the clients. This is because it costs just as much to administer a small account, as a large one. Several methods have been devised to persuade small investors to make larger deposits, and the most potent -which dates from 1930 - is the 'investment programme', or 'contractual plan'. The investor is persuaded to make, not just a single investment, but to pay a regular monthly sum for ten or fifteen years. Mutual fund organizers say that this makes the benefits of stock market investment available to even the most limited incomes, because it makes a smaller initial payment possible. That may be so, but the programme arrangements are so often so complex that the customers do not understand just how much of what they pay over is taken in charges. When they were introduced in the Thirties, 'programmes' involved some truly horrendous abuses. Not only did companies compute inflated charges for themselves: they extracted, in the small print, rights to take these charges out at the beginning of the programme. Sometimes they took the
whole
of the first twelve monthly payments in charges, so that an investor trying to 'redeem' after making his first year payments would get
nothing
back.
whole
of the first twelve monthly payments in charges, so that an investor trying to 'redeem' after making his first year payments would get
nothing
back.
Thus was created the notorious 'front end load'.
Congress then fixed a maximum charge, something never done for any other kind of shares. It was laid down that no more than 9 % of the total money paid over to complete a programme could be extracted in charges. Further, mutual fund companies were prevented from taking more than half of the total charge out of the first year's payments. Even so, when the Wharton School of Business made a survey for the sec in 1962 they found that about 40% of us mutual fund buyers had not understood the effect of the 'front end load' on their investment.
1
The thing people find hardest to grasp is that mutual fund sales loads are not a percentage of the sum invested - as are stockbrokers' commissions - but are charges removed before any money is invested. Therefore, in the early stages of his programme the customer is putting up nearly as much money to pay off the salesman as he is actually investing for his own
1
The thing people find hardest to grasp is that mutual fund sales loads are not a percentage of the sum invested - as are stockbrokers' commissions - but are charges removed before any money is invested. Therefore, in the early stages of his programme the customer is putting up nearly as much money to pay off the salesman as he is actually investing for his own
1
Special Study of Securities Markets, sec 1964. Vol 4, page 107.
benefit - and if he has to redeem, he will get back less money than he has paid over.
The effect of this is to add greatly to the risks of investment for the small investor, because he can very easily lose money even when the market is going up. It is hard to assess the workings of these risks, even within the regulated us industry, because the relationship of purchase time to market movement is so complex. Still, in a set of ten-year programmes which ran from 1951 to 1961 - a period in which the market went up 175 % - nearly as many investors came out with losses (24.1%) as came out with profits (27.4).
1
The majority of investors continued payments, so their fortunes could not be pronounced upon. Of course anyone taking out a new programme in 1961 would have been ideally placed to be hit by the front end load
and
the market break of 1962 during his first year's payments. And the remainder of the decade afforded numerous opportunities for redeeming at a loss. (The sec has proposed the abolition of the front end load, but so far, without result.)
1
The majority of investors continued payments, so their fortunes could not be pronounced upon. Of course anyone taking out a new programme in 1961 would have been ideally placed to be hit by the front end load
and
the market break of 1962 during his first year's payments. And the remainder of the decade afforded numerous opportunities for redeeming at a loss. (The sec has proposed the abolition of the front end load, but so far, without result.)
Bernie Cornfeld clearly grasped at a very early stage the dramatic effects of a front end load in generating commissions out of the money available for investment at any given moment. It worked in this manner:
An IOS salesman, ego tucked firmly into his pocket, enters a 'prospect's' home, and persuades him that if he pays over $3,000 today for an investment in the Fund of Funds, he will get back $9,000 in ten years' time. If the prospect pays up, a sales charge of $255 dollars is cropped off his money, of which $195 goes to the salesman (less any overrides to which he may be subject) and $60 goes to IOS.
The prospect may be deeply moved by the 'presentation', by the wonders of Fund of Funds concept, and by the bounding Wall Street market. (Between the end of 1962 and the beginning of 1965, the great years of the Fund of Funds, the Dow Jones climbed almost without faltering from 650 to the magic 1000, and the IOS men were all equipped with charts which showed FOF ascending yet more speedily.) But the prospect still might say: ‘I don't have three thousand bucks, I've only got a
1
Special Study.
hundred.' If the salesman takes the $100 as an outright payment, he will earn only $6.50 for his evening's persuasi
on. So the conversation will develop like this: Salesman: 'How much could you save each month?' Prospect: 'Well, I might manage $25 a month.' Salesman: 'Fine. Invest $50 now, and $25 every month for the next ten years, and you will have
six thousand dollars
at the end.'
six thousand dollars
at the end.'
What this amounts to is a total investment of $3,000. Of the total 'programme' payments, $325 will be made in the first year. Of that $325, the customer loses half straight away, with the salesman getting $120, and IOS keeping $40 or so.
It may not amaze anyone to learn that the charges levied on the IOS programmes were higher than the maxima permitted by the US Investment Company Act. They took half of the first
thirteen
payments, not of the first twelve. And IOS added on an 'administrative service fee', which increased the total charges on the life of the programme to 12%, instead of 9%. Nor was this all.
thirteen
payments, not of the first twelve. And IOS added on an 'administrative service fee', which increased the total charges on the life of the programme to 12%, instead of 9%. Nor was this all.
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