The Investment Trust

THE investment trust is the outstanding financial development in this country in recent years. With a few exceptions, it was comparatively unknown among American investors as recently as 1920. whereas today it occupies an important position among our financial institutions. The fact that investment trusts have absorbed upward of half a billion dollars of American investors’ capital during this period is eloquent proof of the powerful appeal of this type of investment — an appeal resting partly upon the high degree of stability associated with the diversification of risk in the investment trust’s portfolio, and partly upon the expectation of profits attendant upon the unusual opportunities for investment and reinvestment available under investment-trust operation.

The genuine investment trust comes into being in any fully developed country which has accumulated a surplus of capital beyond that amount necessary for its own needs. It is the child of prosperity, so to speak. Its primary economic function is to assist in the absorption of this surplus by distributing it elsewhere in the world, wherever legitimate demand for it exists under circumstances sufficiently stable to attract capital for investment. It is inevitable that in a country which has a large surplus of capital the level of return from investments will be lower than in a country where the demand for capital exceeds the local supply. It is upon this differential in the return upon capital, continuously varying throughout the different markets of the world, that the genuine investment-trust operation is based — it is upon such a foundation that if performs its most valuable economic function.

There are many and varied definitions of the title ’investment trust,’but when this title is intended to convey the characteristics long associated with genuine British-type investment trusts, the above conditions must prevail. From the standpoint of sustained, profitable operation, the desirability of this international scope of activities cannot be overemphasized, for there has never occurred a time when all the desirable investment markets of the world have been at the same level at the same time, and it is most unlikely that such an economic millennium ever will occur. It is obvious that a portfolio of securities accumulated under this genuine, international investment-trust operation represents the ultimate in diversification of risk, being distributed not only among large numbers of separate securities, but also among many countries, and under economic conditions which naturally favor the most attractive field.

Now, keeping in mind that the above comments outline the genuine investment-trust operation, it is interesting to examine briefly into the many adaptations of this plan embraced in so-called investment trusts which are being presented to American investors in such large numbers to-day. Calling a financial enterprise an investment trust does not make it such, and already the use of this title here has become so widespread as to call for legislation to curb its abuse. Many of our American investment trusts, having little in common with the genuine British-type trust except, a degree of diversification, are presenting this aspect of their affairs as though it were a sort of investment panacea, representing by itself the essence of investment-trust merit. Diversification is valuable, but it is not a substitute for opportunity. Diversification of risk, in tremendous degree, has long been available among certain investment securities, such as bank and insurance shares, without in any sense carrying with it that peculiar opportunity for profit associated with the international operation of the genuine investment trust.

It is probably a fair statement that the most vital distinction between the vast majority of our American investment trusts and the genuine British-type trust has to do with the scope of operations. Where the British trusts are largely international in scope, most American trusts are national. It is a comparison of the many-market trust with the one-market trust, and all the ballyhoo about diversification from now until doomsday will not offset the obvious limitations of one-market, or national, operation, as compared with many-market, or international, operation. It does not matter how splendid a market our own American market may be — it remains forever subject to cycles, going both up and down, like every other market.

It is not improbable that a large percentage of those American trusts which confine their activities to a general list of American securities will be forced to liquidate under the pressure of a real declining market — not necessarily liquidation in the sense of disastrous failure, but in the more literal sense of winding up a business due to the end of its opportunity. Perhaps by becoming international in scope, thus largely eliminating the peril of the falling single market, this liquidation may be avoided, but such operation requires a very costly organization of experts and world-wide connections and knowledge which cannot be created overnight. Genuine investmenttrust operation cannot be run as a casual byplay to some other banking operation.

It may be noted in passing that the singlemarket trust lacks the valuable economic usefulness of the international trust. It does not provide new outlets for the surplus capital which it employs — it merely redistributes it among the same sources from which it came. Its operation has a tendency to stabilize prices of securities locally, but does not in any sense retard the declining level of security yields brought about by the existence of the surplus of capital. It performs a Valuable function, but one which is subject, to distinct limits, both in the degree of diversification which it can obtain and in the capacity for sustained profitable operation.

Another important classification among our American investment trusts has to do with the degree of flexibility permitted in the selection and control of the portfolio. In the main, two divisions exist—the fixed, or rigid, type, and the open, or management, type. Generally speaking, the fixed trust confines its activities to a predetermined list of specific securities, doubtless in the belief that such concentration is very effective, and that the judgment and caution exercised in the selection of the eligible list are capable of providing for all future contingencies. Diversification is thus presumed to make management unnecessary, notwithstanding its original indispensability, and it is a curious fact that trusts of this type are often presented to the investing public as organizations in which the evils of management have been permanently eliminated.

The main principles of the fixed trust are retained in modified form by those quasifixed trusts which provide in varying degree for substitution and elimination in their portfolio. This modification is on the side of prudence, and leans toward flexibility of control — a tendency which, when progressively pursued, ultimately results in that high degree of freedom of management and flexibility of control which is the outstanding characteristic of the management trust. This latter type is the exact opposite of the fixed type. It recognizes that continuous management is essential to success, and delegates broad powers to it, in the same sense that such powers repose in the directorate of a national bank, subject to legal restrictions. When there is superimposed upon such flexibility of control the necessity of conforming to strict investment standards for every transaction, the result is a combination of management freedom and investment safety which is productive of the utmost efficiency in investment-trust practice.

There are also certain American financial companies, calling themselves investment trusts, whose portfolios are made up exclusively of securities of a specific type, rather than a broad diversification among many types. When this concentration is applied to such securities as bank stocks, insurance stocks, and public-utility common stocks, even though entirely composed of American securities, the difficulties in the way of profitable operation during a falling American market are rendered less acute exactly in proportion as such specialized portfolios are composed of securities which, in themselves, are susceptible of continuous appreciation in value, largely apart from general market cycles. Moreover, the investments of such a company are made for long-pull appreciation, rather than for turnover purposes. These financial companies ought not to be classified as investment trusts at all, having ample merit in their chosen fields without beclouding the nature of their operation by an erroneous name, especially since this produces confusion in the minds of investors.

ARTHUR W. JOYCE