Acquired
00:17:16 · Ben Gilbert, David Rosenthal
[00:17:16] S0: the year. Dumping more dollars in, and we'll keep buying more stuff in the basket. [00:17:21] S1: Yep. And that also means that investors in the fund can come and go as they please. There's no lockups. It doesn't have to be a set number. You you buy into the fund. You hold it for a while. Hopefully, it appreciates. You can sell out of the fund. It's everything we know today about mutual funds, but until this concept of an open ended fund was pioneered, you couldn't do this. Now, you mentioned if Americans held stocks at all at this point in time, they held individual stocks through brokers. These funds came to be distributed exactly the same way through stockbrokers. You would call up your Merrill Lynch broker, and instead of saying, hey. Give me five shares of General Electric. You'd say, hey. Give me a couple units of the Massachusetts fund, etcetera, etcetera. [00:18:07] S0: Yep. And so the marketing, the distribution, it relies on this broker dealer network to sort of sell the funds on behalf of the the fund management company itself. [00:18:18] S1: Yep. And the brokers were getting paid by this. [00:18:22] S0: Oh, yes. [00:18:23] S1: Oh, were they ever. So they would take what's called a sales load of usually, like, seven and a half to eight and a half percent of every dollar that a client was putting into the fund. The fund manager would then kick back to the broker as a spiff for putting their clients in the fund.
00:18:23 · David Rosenthal, Ben Gilbert
[00:18:23] S1: Oh, were they ever. So they would take what's called a sales load of usually, like, seven and a half to eight and a half percent of every dollar that a client was putting into the fund. The fund manager would then kick back to the broker as a spiff for putting their clients in the fund. [00:18:41] S0: And it's a kickback out of the money that was just invested. So if you're investing a $100 into one of these funds, well, actually, only 91 and a half dollars are going in as the investment, and the rest is going right out as this effectively distribution fee. [00:18:58] S1: Yeah. To your friendly neighborhood stockbroker. [00:19:00] S0: Now the funny thing is if if we didn't have the context that we have today, which is I invest a $100 and basically a $100 goes into the thing that I'm investing in, or at least that's the way it kinda feels. This was normal. Paying for distribution is a very normal thing across every business and every sector. You have to incentivize people to push your product through marketing, through advertising, through sales commissions, through hiring a giant sales force yourself. These are often very large costs. I mean, for example, retailers often double the price of something when they sell it to the public, but the revenue here is not $100. The revenue to the fund is, like, $2 per year in fees. So paying $8 to the broker dealers is a giant egregious amount to sell the product. It's like four times the amount that the fund itself actually makes.
00:19:00 · Ben Gilbert, David Rosenthal
[00:19:00] S0: Now the funny thing is if if we didn't have the context that we have today, which is I invest a $100 and basically a $100 goes into the thing that I'm investing in, or at least that's the way it kinda feels. This was normal. Paying for distribution is a very normal thing across every business and every sector. You have to incentivize people to push your product through marketing, through advertising, through sales commissions, through hiring a giant sales force yourself. These are often very large costs. I mean, for example, retailers often double the price of something when they sell it to the public, but the revenue here is not $100. The revenue to the fund is, like, $2 per year in fees. So paying $8 to the broker dealers is a giant egregious amount to sell the product. It's like four times the amount that the fund itself actually makes. [00:19:50] S1: Right. Okay. So that's number one to understand about these new open ended mutual funds. Number two, also might be crazy or not crazy depending on your perspective. These new funds, like the Massachusetts Fund, weren't really set up for the benefit of their customer base, the fund holders. Rather, they were created and organized by the investment managers managers who started and ran them with the express purpose of generating profits for themselves. [00:20:21] S0: Right. It's a business.
00:20:21 · Ben Gilbert, David Rosenthal
[00:20:21] S0: Right. It's a business. [00:20:23] S1: And the way that that happened was the people who set up the fund created a separate company called the management company that had a contractual relationship with the fund to get paid a percentage of assets that would, you know, be their revenue. And, ultimately, this is a very high margin business, their profits. [00:20:40] S0: This is effectively the way that all finance works today. There's a management company that performs the act of advising all of the investments in each of the individual funds that the principals own and run it like a business. [00:20:53] S1: Yep. And that management company would be responsible for three things regarding the fund. One, making investment decisions, allocating, you know, the capital. Two, controlling marketing and distribution, which as we talked about, mostly was just turning around to whatever their favorite network of stockbrokers was and kicking it over to them for additional fees. And three, managing the, like, back office and administration of the funds. So, like, the register, the fund holders, the investments, the allocations of shares, tax, etcetera, etcetera. [00:21:24] S0: Legal compliance, bookkeeping, making sure to communicate the prices of the assets with the newspapers so they can print it, all the administrative stuff.
00:21:24 · Ben Gilbert, David Rosenthal
[00:21:24] S0: Legal compliance, bookkeeping, making sure to communicate the prices of the assets with the newspapers so they can print it, all the administrative stuff. [00:21:34] S1: Yep. And the way that the Massachusetts Fund worked is the management company just got paid a fixed percentage of the assets under management that year for the fund. So you can see the immediate conflicts of interest all over the place here. If management of the fund gets paid solely based on the size of the assets in the fund with no penalties or rewards for actual investment performance, well, you're basically just incentivized to grow the fund as large as possible and market it as best as you can and skim a lot of fees off the top. [00:22:14] S0: There there's a tiny bit of performance benefit built in because if the assets under management grows organically by the investments performing well, the fees grow, but it's very different than the way that a lot of funds would go on to be structured later with carried interest or a promote or some sort of performance incentive. [00:22:31] S1: Hurdle rate. You know, it it gets to benchmark, etcetera, etcetera. None of that. Yes. Investment returns are but one sort of arrow in the quiver of management companies at this point in time to grow their profits, and these profits could be very, very, very large. So let's say, for example, you have a $100,000,000 fund, which was reasonable even in that day. Yep. And it would have a management fee of, like, one and a half percent of assets annually. [00:23:03] S0: For a public equities fund.
00:23:03 · Ben Gilbert, David Rosenthal
[00:23:03] S0: For a public equities fund. [00:23:05] S1: Right. Right. So as a management company group in this hypothetical $100,000,000 fund, you'd be taking 1 and a half million dollars a year home, rain or shine, in 1950. That's like $20,000,000 adjusted for inflation today. [00:23:21] S0: And sometimes up to 2,000,000 because I'd I'd seen the number 2% too for mutual funds in this era. And this is, again, listeners, for mutual funds, baskets of publicly traded stocks that are just listed publicly to buy on exchanges. And these funds, in exchange for picking them, putting them in a basket, and administrating it, are charging 2% to do that. [00:23:43] S1: Yeah. And oftentimes, they're not even doing the administration. They're not doing the distribution. They're outsourcing that to, you know, stock workers. They're outsourcing the administration too. So all they're doing is picking stocks and getting a lot of money for it. [00:23:55] S0: So the things we've talked about so far are the one and a half, 2% management fee. There's the eight and a half percent sales load, so that bumps you down from whatever your current principal is to even the on day one when you enter the fund, you know, being down eight and a half percent. So you have that sort of to overcome. And then there's a third thing too, which is transaction fees at this point in time are very, very high. If the fund needs to go and trade stocks to add things to the fund or take things out of the fund, there were very, very large transaction fees relative to today to make those trades.