Investment: A History

AS THE INVESTMENT LANDSCAPE democratized in the eighteenth century, new clients and new forms of investments began to emerge. These new clients included individuals who were not members of the socioeconomic elite and eventually their retirement plans, endowments, foundations, and still later, as mineral wealth discoveries became widespread in undeveloped and developing countries, sovereign wealth funds. The needs of these new clients were met by life insurance, savings accounts, investment advisers, and mutual funds. This chapter examines these new clients and the forms of investment that were developed to serve them. These developments represented a new form of economic freedom, one previously unavailable to the vast majority of people throughout history. This new freedom was supported by expanding the types of vehicles available to help these investors put their accumulated surpluses to work.

The plight of the individual investor is distinct from the situation confronted by an institution or a corporation. Rather than facing the relatively straightforward fiduciary responsibility of a business or nonprofit organization, individuals must consider a range of complications and uncertainties. In addition, the individual investor may be, or at least may feel, subject to duties that do not impinge on the operations of an institution or business. Unlike the officers of a corporation, the individual is personally liable if his or her assets are not sufficient to meet his or her liabilities. And entirely apart from contractual obligations, an individual may feel an obligation to support family or community financially beyond any extent implied by law. No dead person is required to provide money for his survivors, for example, but people still buy life insurance with survivor benefits. In the words of John Donne, “No man is an island, entire of itself.”

John Maynard Keynes included a basic theory of how savings and consumption are distributed across a lifetime in his highly influential The General Theory of Employment, Interest, and Money in 1936. He hypothesized that “men are disposed, as a rule and on average, to increase their consumption as their income increases, but not by as much as the increase in their income.” Though accepted at first, new empirical studies in the years following publication cast some doubt on the accuracy of Keynes’s theory.1

In 1954, Franco Modigliani introduced his life-cycle hypothesis of savings and consumption. He suggested that individuals choose to save their money for retirement to smooth their consumption levels across a lifetime, saving during their working years, hitting peak wealth just before retirement, and depleting their saved funds during retirement when they are no longer earning a full income. From this model, Modigliani sketched the macroeconomic implications of the life-cycle hypothesis. While it had long been known that saving money for advanced age is a prudent idea, Modigliani and his student Richard Brumberg expanded economists’ understanding of savings by building a useful formal model and considering its larger significance. (Modigliani would later win a Nobel Prize, in part for the life-cycle hypothesis and in part for his work with Merton Miller on firms’ capital structures, which is described in chapter 7 of this book.)²

Three years after Modigliani and Brumberg published their pioneering paper, Milton Friedman presented the permanent income hypothesis, a theory that disaggregates a person’s income into “permanent and transitory” components. Friedman suggested that the permanent component determines a person’s decisions about how to save and spend money over a lifetime, with temporary fluctuations not affecting those decisions significantly. In addition, he considered the investor’s time horizon to be infinite and considered the investor to be saving for his or her inheritors, while Modigliani and Brumberg minimized the significance of bequests.3

More modern theories have built on the contributions of Keynes, Modigliani, and Friedman by incorporating other findings in economics and the social sciences, particularly regarding how people deal with the uncertainties of life and how they balance their short- and long-term interests, to build a more holistic theory of savings and consumption.⁴ This survey of the most important theories of savings and consumption provides a framework for understanding when and why people choose to save and spend their money.

Now we turn to the details of how they accomplish these objectives. As members of the broader public have gained access to investment opportunities, they have been able to use them for more than just straightforward financial gain. Indeed, the modern financial system provides tools to help people navigate the messy and complicated economic aspects of human life.

As discussed at length in chapter 3, the emergence of the concept of retirement is entirely linked with the democratization process in which nonelite individuals were able to access investment and wealth-building activities. The rise of the individual as a new investment client also entailed the rise of retirement clients—notably, pension plans and defined contribution plans, which are among the fundamental underpinnings of modern retirement for millions of Americans. The 1974 passage of ERISA gave pensions favorable tax treatment in addition to creating the Pension Benefit Guaranty Corporation to provide insurance for plans that did not have adequate funds to disburse to beneficiaries. However, in the following decades, many employers shifted away from defined benefit plans and toward defined contribution plans. By the end of 2012, defined contribution plans held $5.1 trillion in assets.⁵ These plans, such as 401(k) plans, 403(b) plans, and 457 plans, are not managed by a single sponsor managing one fund. Instead, each employee controls his or her own account; the individual makes allocation decisions in accordance with his or her own risk tolerance and savings needs. This mitigates the risks associated with unfunded pension liabilities in many defined benefit plans, but it shifts the risk of investment loss and the management of the assets to the beneficiary. Very likely defined contribution plans will continue to be the employers’ retirement plan of choice because then employers are able to avoid the liabilities and risks associated with defined benefit plans.

While the cornerstone of this democratization process has been the participation of nonelite individuals, the proportion of capital contributed to many asset classes from individuals directly has been declining materially in recent decades. Instead, individuals are increasingly being replaced by either direct fiduciaries for their money or other institutional pools of capital from which the individuals benefit indirectly. New institutional clients like endowments, foundations, retirement plans, and later sovereign wealth funds came into being in order to support the collective investment needs of these individuals. As a specific example, institutions held a mere 6.1 percent of the public equity outstanding in 1950, but the figure had grown to 50.6 percent by 2009.⁶ These institutions are the gatekeepers of a much greater amount of capital than they used to be; in part because of this, the growth in the investment management industry has accelerated as fiduciaries are hired to intermediate between individuals and their investments.

Investment has been professionalized, though the jury is still out on how much this professionalization has resulted in greater effectiveness. Although the vast scope of this professionalization is quite new, the process of hiring outside experts to manage asset holdings has a long history, as noted in chapter 1’s discussion of Mesopotamian, Egyptian, Greek, and Roman estate and investment management. Defined benefit plans like pensions are normally overseen and managed by investment professionals who are charged with managing the assets exclusively for the benefit of the plan participants. To that end, there are regulations prohibiting the plan from owning too much of the stock of the company for which the employees work. In addition to a conflict of interest, this situation would expose beneficiaries to the risks of company failure and the potential inability of the firm to meet unfunded pension liabilities.

The amount of assets under management by the endowment does seem to matter in terms of investment success. There is an abundance of empirical research suggesting that the larger endowments outperform their smaller peers. There are likely a variety of reasons for this, including the ability to support a talented team of professionals, to diversify properly, and to access investments with higher minimum size requirements.7 An endowment’s investment profile tends to be one geared toward the preservation of capital; the goal is to generate consistent returns while avoiding substantial drawdowns. Endowments are also able to bear some illiquidity, investing in vehicles like private equity, venture capital, and other nonpublic opportunities. They are able to do so because their intended lives are often indefinite and their size relative to yearly spending tends to be large.

Endowments must weigh the trade-off between asset preservation and growing spending needs to support new programs and initiatives.⁸ The question thus becomes how much is prudent to spend, given the uncertainty associated with future investment returns and capital inflows and the need to support later generations of beneficiaries. In 2011, the average annual effective spending rate for private colleges and universities was 4.6 percent, and for their public counterparts 4.3 percent.⁹ In addition, educational endowments enjoy the benefits of tax exemption that allow them to compound their returns at a faster rate.

In 1972, a standard code of procedures and rules for the investment activities associated with managing an endowment fund was established in the form of the Uniform Management of Institutional Funds Act (UMIFA) by the National Conference of Commissioners on Uniform State Laws. Much later, the Uniform Prudent Management of Institutional Funds Act (UPMIFA) was passed in 2006 by the same body. UMIFA specified that assets should be deployed across asset classes (diversification) while UPMIFA updated those codes by additionally stipulating that investments must be executed in accordance with a prudent person standard and “in good faith.”10 Diversification is continuing to be a highly effective investment strategy for endowments. By way of example, as of June 2005, the average educational endowment held 53 percent in domestic equity, 23 percent in domestic fixed income, and 5 percent in cash.¹¹ Six years later, by June 2011, the average educational endowment’s asset allocation was 16 percent in domestic equities, 10 percent in fixed income, 17 percent in international equities, 53 percent in alternative strategies, and 4 percent in cash or other general assets.¹² In short, endowment diversification is following the current investment trends by becoming more international, as well as taking advantage of more niche strategies.

The foundation, in its modern form, dates back to the turn of the twentieth century, when many industrialists found themselves with enormous wealth they could funnel toward the improvement of society. Perhaps it was Andrew Carnegie who expressed most clearly the duty some of the more philanthropic industrialists felt at the time, noting that a fortunate person of wealth should “consider all surplus revenues which come to him simply as trust funds, which he is called upon to administer…to produce the most beneficial results for the community.”¹³

One of the first modern foundations was the Russell Sage Foundation, created in 1907 by Margaret Sage with funds from her recently deceased husband, Russell Sage, who had amassed considerable wealth as an investor in railroads and telegraph companies. When he died at the age of eighty-nine, he left more than $63 million to his wife. In her lifetime, Margaret would give away $75–$80 million to various philanthropic funds. Much of her work was oriented toward the academic and the practical study of poverty and other social issues at universities and other institutions. Some of it was directed toward labor issues, including the Pittsburgh Survey, which analyzed the often ghastly labor conditions in the steel industry, resulting in the eventual alleviation of some of the most serious issues.¹⁴

Shortly thereafter, in 1911, Andrew Carnegie founded the Carnegie Corporation of New York “to promote the advancement and diffusion of knowledge and understanding.” By the time Carnegie had established the Carnegie Corporation, he had already disbursed some $43 million for public libraries and another $110 million for other charitable uses. However, Carnegie wanted to transfer the power to make his philanthropic decisions to a permanent institution. Writing to his trustees, Carnegie explained, “Conditions upon erth [sic] inevitably change; hence, no wise man will bind Trustees forever to certain paths, causes or institutions. I disclaim any intention of doing so. On the contrary, I giv [sic] my Trustees full authority to change policy.” To this day, the Carnegie Corporation of New York still exists and contributes money to a wide array of educational institutions, domestically and abroad.15 Likewise, in 1913 John D. Rockefeller set up a foundation, which has given funds to medical schools, the American Red Cross, and other initiatives oriented toward medicine and health care around the globe.¹⁶

The relationship between foundations and the tax code was specified with the enactment of the Revenue Act of 1913, which made charitable foundations tax exempt. The Revenue Act of 1917 allowed individuals to make tax-deductible contributions, and the Revenue Act of 1918 reduced the tax burden associated with bequeathing assets to private foundations. The pace of the creation of independent foundations slowed during the interwar period, but after World War II, there was a considerable increase in corporate foundations, a fact undoubtedly linked to the country’s return to greater economic prosperity.¹⁷

Soon though, in the 1960s, some foundations found themselves at the center of national debate because the regulations allowed them to be less transparent than other charities. Further, there were added concerns that some foundations were being used as tax shelters rather than providing real benefits for the community. The Tax Reform Act of 1969 required foundations to make payments to the federal government and also established a minimum annual percentage of assets that foundations had to distribute each year in order to avoid taxation and other regulatory consequences. These provisions were later altered to be more favorable for the creation and operation of foundations, contributing to their growth from the 1980s onward.¹⁸

Foundations are an important source of investment activity, due in no small part to the considerable assets they control: $622 billion as of 2010.19 Trustees are tasked with managing budgets and with making investment decisions. Unlike the task of educational endowments, the task of foundations is slightly more complicated because of the minimum distribution foundations must make of their total asset base, lest they pay taxes and other penalties. As a result of this required minimum spending, trustees often focus on managing new contributions and being careful about investment activities in order to avoid having the foundation’s asset base fall materially over time. The investing program of a foundation tends to otherwise look like that of an educational endowment, with an orientation toward capital preservation, broad diversification, and careful risk taking.

Like educational endowments, private foundations enjoy the benefit of tax deductibility of contributions as well as exemption from paying federal income taxes on investment earnings. While endowments usually directly benefit the institution’s goals and programs, foundations often provide grants and other forms of aid to a charity that then distributes the funds to other programs.²⁰ In other words, foundations serve as the benefactors not just of the individuals they ultimately serve but also of the charities that assist the ultimate target population.

Increasingly, some foundations are attempting to marry their fundamental operational goals with their investment goals. The William and Flora Hewlett Foundation and the John D. and Catherine T. MacArthur Foundation, for instance, vote their shares of public corporations in a manner that reduces or avoids harm done (or ideally, produces benefit), and both foundations are led not just for financial gain but also for overall social gain.²¹ Others make very specific mission-related investments, like microfinance loans to the impoverished, lending for affordable housing, purchasing assets or equity interests in clean energy, and investing in other endeavors with clear social goals. Although it is difficult to say precisely how widespread formalized mission-related investment is, the Foundation Center conducted a poll in 2011 of over 1,000 foundations and found that 14.1 percent were actively engaged in such investment.²² It seems likely that this trend will continue as foundations find creative ways to deploy not just flows of cash but also their assets in ways that benefit their target populations.

Foundations are plentiful in the United States, with a total of 86,192 across the country as of 2012. They can be categorized in three general ways: independent foundations, corporate foundations, and operating foundations. Independent foundations are typically affiliated with one or several individuals who tend to be affluent philanthropists. Corporate foundations are associated with a company, and their budgets tend to be derived from that profit-earning entity. The last is the operating foundation, which directly spends resources. In 2012, foundations distributed a total of $52 billion—roughly 67 percent from independent foundations, 12 percent from corporate foundations, and 11 percent from operating foundations. The remaining 10 percent comes from community foundations, which are charities that draw funds from a wide array of different donors.23 While the sources of foundation assets often originate from single wealthy donors, families, or corporations, their capital deployment strategies have contributed to the overall trend of democratization.

The amount of attention sovereign wealth funds have received from the public in recent years is remarkable. Despite their size, sovereign wealth funds as a class of investment tended to fly below the radar of the public until 2007. Indeed, the term sovereign wealth fund was not even in modern parlance until about 2005, when Andrew Rozanov first used it in his article “Who Holds the Wealth of Nations?”²⁴ Sovereign wealth funds are another class of capital pool central to the modern investment scene, managing a total of $6.4 trillion as of March 2014.²⁵ Similar to endowments and foundations, sovereign wealth funds manage money for the benefit of the organization to which they are connected, the main difference being that the funds of a sovereign wealth fund belong to a nation or state rather than an institution. Their assets are derived not from donations or charitable contributions but, rather, from the sale or licensing of natural resources, excess governmental revenue, and foreign exchange reserves produced from positive trade balances.

Like endowments, sovereign wealth funds help manage money over time in two fundamental ways. In the short term, sovereign wealth funds serve as a buffer; when there is a shock in revenues or costs, the sovereign wealth fund can be drawn upon to normalize the budgeting process. This is especially crucial for nations that rely on natural resource sales. By smoothing spending, the sovereign wealth fund helps temper the damage done to the economy by adverse commodity price movements in exported goods. In the long term, the accumulation of wealth in a sovereign wealth fund ensures that subsequent generations can experience the benefits from the sale of resources that are, in most cases, finite.

There is some disagreement about which pool of capital was actually the first sovereign wealth fund. Some observers point to CalPERS, the California Public Employees Retirement System, established in 1932.26 It was set up to manage funds for the benefit of the employees of the state of California. However, while it meets the IMF’s definition of a sovereign wealth fund, it is unusual in several respects. For one, CalPERS has individual beneficiaries, whereas the beneficiary of a sovereign wealth fund is the state. Furthermore, a sovereign wealth fund does not generally have explicit liabilities as a retirement fund does; indeed, to the extent that sovereign wealth funds have genuine liabilities, they tend to simply be to another part of government.²⁷

In light of this, most observers agree that the first true sovereign wealth fund was the Kuwait Investment Authority, which was created in 1953.²⁸ Today, one of the largest sovereign wealth funds with around $548 billion, the Kuwait Investment Authority is in charge of investing the assets of two funds: the Reserve Fund for Future Generations (into which a percentage of annual oil revenues is directed) and the General Reserve Fund (the general fund of the government that receives revenue and disburses expenditures).²⁹ This fund has fulfilled its mission of helping the nation weather difficult times. As Bader Al Sa’ad, managing director of the Kuwait Investment Authority, has pointed out, the sovereign wealth fund supplied funds for normal budgeting during the Iraqi occupation of Kuwait in the early 1990s.³⁰ Had the sovereign wealth fund not existed, Kuwait would have been forced to borrow expensively, tax heavily, or rely on other governments for assistance.

More sovereign wealth funds emerged in the 1970s, including the Abu Dhabi Investment Authority, presently one of the largest sovereign wealth funds in the world.³¹ Many of these arose in the latter portion of the decade as oil prices climbed. This is a pattern that has continued—when commodities prices skyrocket or have sustained periods of loftier values, sovereign wealth funds are often formed to capture this profit. This has occurred not just in the case of oil but also, for instance, in the case of copper in Chile. In the 1990s, prices for commodities remained modest and few new sovereign wealth funds came into existence; but in the next decade, as commodities prices increased and as the merits of SWFs became more broadly understood, many new funds opened. Indeed, just between 2005 and 2012, more than thirty new sovereign wealth funds were born.³²

There has been some anxiety, largely in the West, over the possibility that SWFs could be used to adversely affect financial markets for political purposes or to serve as a source of geopolitical leverage. The reality of the situation, however, is different. First, there has been virtually no evidence to date that sovereign wealth funds have any real interest in perpetrating such damage. Many sovereign wealth funds have proven quite economically rational and have operated with largely financial, not political, intentions. Second, if a sovereign wealth fund did seek to do serious political harm, it would generally harm itself in the process. For instance, if a fund initiated asset fire sales—the rapid unloading of assets to depress their prices—the fund itself would be seriously damaged. There would have to be a particularly potent motivation for a government to do this. Third, while sovereign wealth funds are an important source of capital, they remain a much smaller pool of capital than many other sources of institutional funds. Sovereign wealth funds are located in a wide array of nations, each with separate agendas, so coordination among them to do more serious damage seems like a remote possibility. The reality is that the evidence to date shows that the concern over sovereign wealth funds becoming political weapons has been a largely unfounded.

That said, the individual investment mandates of sovereign wealth funds are often related to the source of the original funds. Middle Eastern sovereign wealth funds, for instance, often seek to diversify away from commodity price risk, investing in a wide array of other industries. Asian sovereign wealth funds, by contrast, have foreign reserves due to positive trade balances as their source; thus their focus is more about diversifying away from the currency price risk to which they are exposed.33 The investment strategies of sovereign wealth funds also tend to align with the fundamental reasons for their creation. Most sovereign wealth funds tend to be slightly more interested in capital preservation, whereas ones that are centrally concerned with growing the assets often have a slightly higher risk tolerance. But in general, sovereign wealth funds are widely diversified and can manage a wide liquidity spectrum, since they do not have explicitly dated liabilities.

Given the historical trend and the broadening of the conviction in the merits of these funds, the future seems bright for sovereign wealth funds. They are likely to become more plentiful as countries seek to monetize their resources, diversify away risk, and orient the revenue of the country toward a wider stream of income sources.

The democratization of investment required the emergence of new investment vehicles that for the first time sought to meet the needs of the nonelite individual for financial security, accumulation, and management. Life insurance and savings accounts are two of the earliest and simplest vehicles. The development of life insurance includes comical legal strategies, actuarial mathematics, and ethical reactions to the very notion of betting on death. Savings accounts have an equally intriguing history—from the savings societies that were crucial for many working poor to the development of commercial banks that facilitate the transactions that propel the economy, and through the 1970s banking crisis, which required governmental intervention. Then there are the more complex, and often more risky, investments in the form of separate investment accounts and mutual funds. These vehicles are not prestructured and often have more ambitious capital appreciation goals and therefore must accept more exposure to losses as well.

One of the earliest records of a life insurance contract dates back to 1583. A life insurance policy was taken out on a man named William Gibbons for a duration of 12 months by several of Gibbons’s acquaintances. The premium was a small fraction of the death benefit, with a payout ratio of 25 to 2. Gibbons died just twenty days before the end of the year, and the purchasers of the insurance contract believed that they would receive a windfall. The insurers, however, were far from pleased by this and concocted a rather creative legal defense, claiming that the insurance contract was for 12 months, and because the shortest month has 28 days, the contract was really for only 336 days, not 365 days, and thus they were not responsible for the claim. In the end, the court recognized the absurdity of this defense and the insurers were held liable, but the episode speaks to how nascent and often ill defined financial responsibilities in the insurance industry were at the time.34

While simple term life insurance had existed for some time, in 1756 the English mathematician and Fellow of the Royal Society James Dodson devised the level premium plan that allowed policyholders to pay a flat premium, and, in turn, they would receive coverage for their entire lives. With this idea, James Dodson became the father of whole life insurance. He created this system after he himself had applied for life insurance coverage from the Amicable Society, a group offering insurance chartered by Queen Anne in 1706, but was denied for being too old. The Amicable Society was willing to extend life insurance coverage, but only for young insureds.³⁵ Dodson demonstrated that a yearly premium could be charged to cover insureds that properly reflected the mortality risk to the insurer: an insured would pay more than his risk-neutral mortality risk in the early years of the policy but would pay less in the later years, thus creating the flat premium schedule. Dodson eventually solicited the government for a charter to create an alternative life insurance organization that could compete with the Amicable Society. Dodson would not live to see it, but Edward Rowe Mores believed strongly in the superiority of Dodson’s proposal and finally managed to win approval in 1762 for what is called today the Equitable Life Assurance Society, the oldest mutual insurer in the world.³⁶

Life insurance caught on quickly in Great Britain, but other countries were not so quick to adopt it. The notion of betting on death seemed inappropriate to many, as the timing of death itself was perceived to be God given and should be beyond human speculation. Some leaders of religious communities spoke out against the practice entirely. This initial religious reaction has been built into some forms of life insurance; many jurisdictions still have laws requiring the beneficiary to have “insurable interest,” or a legitimate benefit conferred by the survival of the insured, at the origination of a new policy. In other words, to deter sheer betting on death—and of course, to prevent malfeasance—one cannot take out a life insurance policy on a stranger. Over time, we have come to recognize the importance of risk transfer around death, but few people remain excited about the prospect of broad wagering on the timing of any individual’s death.

The religious climate in the United States was more moderate than in many European countries, and many people slowly began to appreciate the value of the product. By the 1840s, the life insurance industry in the United States hit a point of inflection, brought about by two structural changes in the industry. The first was to allow wives to be the beneficiaries of policies in which their husbands were the insureds. Before 1840, many married women were not permitted to sign insurance contracts themselves or to be a direct beneficiary of their husband’s policy because the relationship of marriage itself was not at the time seen as necessarily constituting an insurable interest. Instead, the death benefit would be payable to the husband’s estate, and thus creditors could access the proceeds before his widow. This changed when insurers joined forces with women’s rights activists to promote the passage of laws like the Married Women’s Property Acts, passed by a number of states starting in 1839 and 1840.37

The second structural change the industry experienced in the 1840s was the growth of mutual life insurance companies, or firms whose proceeds went not to shareholders but, rather, to the policyholders themselves. At the end of the previous decade, other life insurers had experienced difficulty accessing the capital markets in the wake of a financial crisis, so mutual life insurers fared much better because they required significantly less seed capital. Largely as a result of these two factors, the amount of life insurance coverage between 1840 and the end of the Civil War grew enormously, and the industry was fully integrated into the American economy.³⁸

Today, life insurance is viewed as part of the bedrock of family financial security: a 2010 LIMRA market research study revealed that 70 percent of American families owned a life insurance policy.39 The majority of life insurers fall into three categories. The first is the stock company, which is owned by shareholders and insures over $13 trillion in face value, or about 70 percent of the US market. The second is the mutual company, which is owned by policyholders and insures over $5 trillion in face value, or about 25 percent of the market. The third is the fraternal society that has a network of lodges and can offer insurance only to lodge members, and these collectively insure about $315 billion in face value, or 1.5 percent of the market.⁴⁰ The balance of the industry is insured by other groups, such as government agencies. The assets of life insurers are invested so that the insurers can meet their liabilities. Historically, most life insurance companies’ assets have been held in fixed income securities. Early on, this typically meant government debt instruments, but over time it grew to include mortgage-backed securities as well as corporate debt. Over time, more public equities have been held by insurance companies (growing at a 5 percent annual clip from 2000 to 2010).⁴¹ The establishment of insurance companies as investment vehicles is directly linked to the vast expansion of individuals who are participating in life insurance, savings, and investment activities.

Chapter 3 discussed evidence of life-cycle savings by female servants in the context of retirement. Here, the analysis broadens to the history of savings vehicles. Savings societies allowed the previously underbanked (most notably, the working poor) to access the benefits of a depository institution, and they grew in prominence in the early nineteenth century. The Philadelphia Saving Fund Society was the first American mutual savings bank, commencing its dealings in 1816. The first chartered US mutual savings bank was the Provident Institution for Savings in Boston, which began serving the public that same year. The number of savings banks grew rapidly, numbering just 10 in 1820 and growing to 637 by 1910, with total deposits growing from $1 million in 1820 to $3 billion by 1910. Their investment mandate was fairly broad, initially being confined to government bonds but later including mortgages, utility debt, and even the common equity of large corporations.⁴²

These savings banks tended to be domiciled in the northeastern United States, where the demographics of a large swath of wage earners employed in industrial jobs were an appropriate match for their intended clients. Developing alongside mutual savings banks were the commercial banks, which were focused predominantly on making loans for profit maximization and had a strong foothold on the frontier portions of the country. The commercial banks required lower capitalization, and their governance structures were not as sophisticated as those of mutual savings banks, where prominent and successful trustees would oversee the soundness of the bank. Therefore, commercial banks tended to make more risky and potentially more rewarding loans, which meant that although they facilitated growth in many areas, they were less stable than their mutual savings banks counterparts.

As greater numbers of individuals were searching for institutions and vehicles with which they could grow their life savings, savings and loan associations (also known as thrifts) came into being. Their original function was to convert deposits into loans made for building, fixing, and refinancing homes, later expanding to include automobile loans and personal lines of credit. These banks were crucial to the construction and modernization of new cities across the United States while allowing individual savers to access a decent rate of return. These institutions allowed savers to make deposits in a variety of ways, including recurring payments at consistent intervals of time, dividend reinvestment programs, and irregular additional deposits to accounts. The depositors later enjoyed the backstop of the federal government when it created the Federal Savings and Loan Insurance Corporation to insure the deposits of these savings and loan associations.

Savings banks survived through the Great Depression and the succeeding decades, even though the banking environment did become more competitive. But the inflation of the 1960s and 1970s proved injurious to these savings banks with interest rate maximums in terms of what depositors could earn for keeping their money in the bank. A high interest rate environment drove depositors to move their money to funds where it could fetch a higher return.43 As rates climbed in the latter part of the 1970s, many mutual savings banks failed. In 1982, annual losses at the mutual savings banks with FDIC insurance were running at a devastating 1.25 percent of total assets.⁴⁴

At the same time, savings and loan associations were also suffering from the effects of high interest rates for similar reasons. The government’s attempt to manage inflation caused short-term rates (the rates at which these institutions borrowed) to increase without the same increase happening to long-term rates (the rates at which these institutions could lend). Savings and loan associations were thus forced to borrow at high rates but to make new loans at lower rates. This situation was further exacerbated by the real estate investments of savings and loan associations, a sector that underwent a broad-based decline in the 1980s, thereby impairing both the collateral and the repayment rates of the underlying mortgages.⁴⁵ Furthermore, the governmental oversight of the associations was significantly deregulated, creating the conditions for very irresponsible lending decisions and, occasionally, outright fraud, including the looting of some associations’ assets by management teams.

The FDIC deployed several different strategies to stem the tide of what would otherwise have been a widespread crisis within these institutions. Fortunately, by virtue of their structures, mutual savings banks did not have shareholders to worry about, and thus the central goal was to protect assets.⁴⁶ The introduction of certificates of deposit with longer maturities and the mergers of banks with other institutions had some positive effects on the industry. In addition, the Garn–St. Germain Depository Institutions Act of 1982 authorized the FDIC to acquire capital instruments from the bank, “net worth certificates,” in order to aid their liquidity positions, which also helped the banks weather this painful inflationary period. With these interventions, the banking crisis of the early 1980s was contained. In total, between late 1981 and 1985, the FDIC aided with seventeen mergers and acquisitions of mutual savings banks involving total assets of nearly $24 billion, which translated into 15 percent of the total assets of FDIC-insured mutual savings banks as of year-end 1980.⁴⁷ At year-end 1995, the cost of all of the savings bank failures was estimated to be about $2.2 billion.⁴⁸

Savings and loan associations fared even worse: from 1986 to 1995, over one thousand savings and loan associations with an excess of $500 billion in assets failed. The Federal Savings and Loan Insurance Corporation would later become insolvent and require a taxpayer bailout to the tune of $124 billion. In 1989, its responsibilities were subsumed by the Federal Deposit Insurance Corporation.49

Over time, savings institutions have come to account for a smaller and smaller part of the economy. Indeed, savings and loan associations and mutual savings banks today hold a much more limited portion of Americans’ savings than they did in the past. A brief study of the quantitative sources demonstrates this transformation of the savings landscape. Data from the Federal Reserve show that although thrift institutions at one time held a greater amount of savings deposits than did commercial banks, this balance shifted decisively in 1982 and 1983. Today commercial banks hold almost six times the savings of thrift institutions.⁵⁰ In May 2014, 78.7 percent of savings deposits and small-denomination time deposits was held in commercial banks. Savings institutions, meanwhile, held 14.2 percent of these deposits, with the remaining deposits invested in retail money market funds.⁵¹

Since the beginning of asset accumulation there have been investment clients—those who have acquired resources and have sought outside experts to manage all or part of their holdings. As discussed at length in chapter 1, ancient Mesopotamians, Egyptians, Greeks, and Romans employed agents to manage their agricultural properties, lending businesses, and trade activities. In many cases, these agents were slaves or commoners who possessed the expertise concerning the assets and activities involved and the time to devote to the task—commodities that the elite owners did not have. Agents were either directly employed by the resource owner or contracted, providing the service for some sort of fee rather than a wage or other form of subsistence.

Private wealth management in its modern form began to emerge in Europe at the end of the Middle Ages, when the traditionally wealthy members of the landed elite began to sell off their land. Likely originating during or after the Crusades, family activities designed for the purposes of preserving, managing, and growing a family’s diversified wealth blossomed in Europe into the modern era. The historical role of separate account management is a critical one, because until the early twentieth century, this was the only way to manage individual or family wealth.

Today separate account management refers to a more modern practice, likely dating no further back than the eighteenth or nineteenth century, wherein a service provider—a bank trust department, independent investment adviser, or other contracting party—is hired to select and manage investments for a wealthy person or family or an institution. The service may include, in addition to specific asset selection, the setting of investment policy, the choice of strategies to achieve it, and the monitoring of the composition and risk profile of the portfolio.

In the past few decades, a broad system of private wealth management has been created, bringing the features of a family office to a wider, albeit still limited, audience. This system takes into account the complicated needs of wealthy individuals, providing for estate planning and, importantly, keeping an asset base secure. Unlike a dedicated family office, private banking does not involve an entire organization devoted to the wealth of a single individual or family. However, private banking does require investors to have a high level of assets, and it provides personally tailored investment advising and other services that commercial bank branches and retail brokerages do not offer.52

J. P. Morgan’s U.S. Private Bank, a division of financial giant J. P. Morgan Chase that is today America’s largest private bank, provides a good case study for understanding the private wealth management industry.53 The account minimums tend to be in the low millions, but its area of traditional focus and strength remains even wealthier investors, with most investors investing at least $25 million. In 2001, in fact, the average person or family invested in J. P. Morgan Private Banking had a net worth of around $100 million.⁵⁴

Across all of its divisions, J. P. Morgan held $1.60 trillion in assets under management and $2.34 trillion in total client assets in 2013. The Private Banking division in particular held $361 billion in client assets under management (22.6 percent of total assets under management, or AUM), with a total of $977 billion in client assets invested in the division (41.7 percent of total client assets). These assets contributed significantly to the firm’s revenues. In fact, J. P. Morgan Private Banking division generated $6.0 billion in revenues in 2013, accounting for over half of the Asset Management division’s $11.3 billion in revenue.⁵⁵

As the democratized investor base has grown, so has the variety of products that cater to it. One more recent innovation is the mutual fund—a vehicle that often involves higher risk and active management (that is, a professional or set of professionals actively making security selection decisions). Although the mutual fund has precursors dating back hundreds of years, it is the modern version, born in the 1920s, that has become the investment solution of choice for the savings and retirement assets of a large segment of the public. The current popularity of the mutual fund comes from a combination of three beliefs. First, individuals believe that mutual fund managers may be better and safer investors than the individuals themselves (in other words, a professional advantage). Second, mutual funds allow broader diversification than one can typically provide on one’s own. Third, many individuals believe that active investors may be able to outperform a passive index by security selection, market timing, or some combination of the two. These beliefs, combined with the ubiquity of mutual funds in most individuals’ investment strategies, illustrate the ways in which the democratization of investment has led to investment innovation and growing professionalism.

A second vehicle that more closely resembled the modern mutual fund because it involved more asset selection rather than just convenient intermediation was created by Abraham van Ketwich in Amsterdam in the summer of 1774. Van Ketwich offered 2,000 shares of an investment pool to the public with the goal of investing in quality debt instruments of governments, banks, and plantations. In this way, with a single initial offering, van Ketwich essentially created an early closed-end mutual fund for sale to the public. All later liquidity was offered only through sale by the owner to another investor. The offering had a prospectus, an administrator of the assets, and a clear description of the two individuals involved in the supervision of the investment decisions of the fund: Dirk Bas Backer and Frans Jacob Heshuyen.⁵⁷ As it turned out, this initial foray was quite successful, and just five years later, in 1779, van Ketwich repeated the process by establishing a second trust with the name Concordia Res Parvae Crescunt, roughly translated, “In harmony all things grow,” a motto that points to the growth of returns when the investors give managers a broader mandate to deploy capital. Van Ketwich preceded Benjamin Graham or Warren Buffett as one of the earliest value managers, noting in his prospectus that the fund would seek out securities priced “below their intrinsic values.”⁵⁸

Founded by Edward G. Leffler, the Massachusetts Investors Trust was the first open-ended mutual fund in the United States, and it remains active to this day under ticker MITTX.59 Unlike van Ketwich, who sold a predefined number of units in a trust that could be liquidated only through sale to new investors, Leffler established a mutual fund that had no fixed number of shares and offered liquidity, not through a secondary sale, but rather through a redemption process. In other words, one could trade in a unit of the mutual fund directly through the issuer, who would then liquidate that person’s share of securities and return the corresponding amount of cash. This fund was quite successful with 200 shareholders and about $392,000 under management after the first year, a much more sizable sum of money in 1924 than it is today. Just four months after Leffler’s launch, Paul Cabot founded State Street Investment Trust, also in Boston.⁶⁰

While these funds did have some early traction, the assets under management were miniscule in comparison with many larger closed-end funds and other investment companies in the 1920s. Indeed, in 1927, open-ended mutual funds were just 3 percent of all assets managed by investment companies.⁶¹ However, the significant declines in value of closed-end funds during the Crash of 1929 made their open-ended counterparts seem more attractive, and by 1936 the Massachusetts Investors Trust had a staggering $130 million under management.⁶² The Revenue Act of 1936 helped too, as it allowed open-ended funds to avoid taxation at the fund level.

Meanwhile, government regulators started to pay closer attention to the slowly blossoming universe of mutual funds as significant misconduct as well as poor performance was revealed in the wake of the Crash of 1929. The government’s goals were to manage the alignment between the adviser and the investor, prevent malfeasance, and instill confidence in the public markets after the Crash and the ensuing Great Depression. A sequence of federal laws had some effect, though of varying degrees, on the industry. The first was the Securities Act of 1933 that required mutual funds to register with the federal government and provide updated versions of the prospectus to investors should it change over time. The second was the Securities Exchange Act of 1934, which mandated federal registration for the brokers (not just the fund itself) involved in managing the assets. This act also required mutual funds to file annual reports to the newly created Securities and Exchange Commission (SEC).63

These acts, while a positive step forward for the industry, did not eliminate all the malpractice of the bad actors. A study conducted by the SEC after the enactment of these laws found some instances of salespeople and managers transferring investor assets between different funds for the generation of fees, with no clear investment objective.⁶⁴ Even though Congress could have adopted a stricter disclosure rule within the framework of the Securities Exchange Act of 1934, it would not really have addressed the underlying problem of abuse by bad actors. Instead, Congress passed the Investment Advisers Act of 1940, which broadened the registration rules and, perhaps most important, included antifraud measures as well as strict custodial provisions. This law was followed later that same year by the Investment Company Act of 1940. It enhanced the precision of the existing law and is credited as the bedrock legislative achievement for the mutual fund industry. It called for clear disclosure of operational processes and fund structures as well as more frequent updates on the financial performance of the fund. It also prohibited affiliated party transactions that would disadvantage the investor by producing unnecessary fees.⁶⁵ In addition, the SEC was allowed to perform on-site inspection of fund financials. Furthermore, the law made it clear that the directors of mutual funds had the same legal and fiduciary duties as directors of other corporations and mandated that no less than 40 percent of the board of a fund be independent of the investment adviser (the SEC would later raise this percentage to 75).⁶⁶

Notably, the law itself was given a mechanism by which it could evolve with the times; the SEC was charged with the power to designate rules and oversee the entities subject to the acts. Congress was aware of the speed at which this industry was growing—after all, its growth is what pressured Congress to act—and also knew it would be injurious to design a set of rules that would hamper investors’ access to value-additive investment opportunities.⁶⁷ This is the hallmark of an impressive legislative achievement—the balance between protection for investors and the continued incentives for innovation and growth.

It was at this point that the market sentiment toward mutual funds became exuberant. There was widespread enthusiasm about mutual funds even in publications that had little to do with finance, such as Better Homes and Gardens, which declared that “there is virtually no possibility that you’ll lose your shirt” by investing in mutual funds.⁷⁰ This unfettered ebullience came to an end with the bear market beginning in 1969 and in the 1970s. Mutual funds did not remain unscathed by the general economic conditions and the oil crisis. Many investors saw steep declines in net asset values, often to the extent of being halved from their peaks. The public became so disenchanted by the decline in many mutual funds that Business Week noted that the fund industry had “an image problem.”⁷¹

However, during this period, the first money market mutual fund, the Reserve Fund, was founded by Bruce Bent and Henry Brown.⁷² The goal of this vehicle was to take very little market risk and preserve capital while earning a small but steady return. Investors were attracted to these funds because of their circumvention of Regulation Q that otherwise capped the interest rates savings institutions could pay, which was a large problem during this inflationary period. The central mission of these funds was to generate returns while not “breaking the buck,” or having the net asset value decline below $1 per unit. Indeed, these funds rarely failed at their mission, with the exception of some funds during the financial crisis of 2007–2009, including, in fact, Bruce Bent’s own Primary Reserve fund, which had some exposure to Lehman debt.

Mutual funds experienced vast asset growth in the 1990s because of three factors. First, mutual funds gained assets through price appreciation as well as investors’ enthusiasm in the bull market of the 1990s. Second, 401(k) plans and IRAs gave much greater access to mutual funds. As defined contribution plans grew and the burden of investing shifted toward the individual rather than the company’s pension plan, mutual funds were a convenient vehicle to which investors turned. Third, with better distribution systems, more product offerings, and fledgling competition from index funds, many mutual funds saw fees decline, particularly on the loads charged to get into or out of them.

The industry is also likely to see continued concentration in multiproduct platforms. Although it does seem at first glance that new product innovation and the ability of multiproduct organizations to offer a range of solutions are positive developments, there is a limit beyond which these may not prove additive for the investor. The purpose of the mutual fund, after all, is to simplify the task of security selection by shifting that burden to a professional manager. If the industry arrives at a point at which the investor has to choose among an endless number of funds, however, the simplification objective may not really be satisfied. Furthermore, within the multiproduct funds, there is a risk that the firm managing a given fund may not be as effective as a team with a single product. A team with a single product, after all, has its own fortunes tied to how each fund fares, whereas a multiproduct manager may be able to ignore or shut down a fund that does not perform well without significant impact on its overall business. These are fundamental but admittedly philosophical questions that will face the industry in coming decades, and only time will tell how they are resolved.