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The origins of mutual funds Back  
Oxford University Press has just published a brilliantly illustrated book ‘The Origins of Value: The Financial Innovations That Created Modern Capital Markets’, written by some of the world’s leading writers on finance history and the history of economic thought. In this extract we relate the very beginnings of mutual funds, (which are now the basis of a €500 billion plus industry in Dublin) in an abridged extract of an article by K.Geert Rouwenhorst, one of the editors of the book.
Compared to direct investments in individual stocks and bonds, mutual funds offer the advantages of liquidity and diversification at a relatively low cost. While the popularity of mutual funds is relatively recent, the origins of mutual funds date back to the early days of organized stock trading.

The Origins of Value

The founding of the Foreign and Colonial Government Trust in 1868 marks the beginning of mutual funds in the Anglo-Saxon countries. However, by that time investment trusts had existed in Holland for almost a century. In 1774 the Dutch merchant and broker Abraham van Ketwich invited subscriptions from investors to form a trust named Eendragt Maakt Magt—the maxim of the Dutch Republic, “Unity Creates Strength.” The founding of the trust followed the financial crisis of 1772—1773, and Van Ketwich’s aim was to provide small investors with limited means an opportunity to diversify. Risk spreading was achieved by investing in Austria, Denmark, Germany, Spain, Sweden, Russia, and a variety of colonial plantations in Central and South America.

The first mutual fund originated in a capital market that was in many ways well developed and transparent. More than one hundred different securities were regularly traded on the Amsterdam exchange, and the prices of the most liquid securities were made available to the general public through broker sheets and, at the end of the century, a price courant—a biweekly publication that in addition to security prices listed real estate transactions and announcements of dividends and security offerings. The bulk of trade took place in bonds issued by the Dutch central and provincial governments and bonds issued by foreign governments that tapped the Dutch market. The governments of Austria, France, England, Russia, Sweden, and Spain all came to Amsterdam to take advantage of the relatively low interest rates. Shares were scarce, and the most liquid issues were the Dutch East India Company, the Dutch West India Company, the British East India Company, the Bank of England, and the South Sea Company. The other major category of securities consisted of plantation loans—or negotiaties, as they were known in the Netherlands. Issued by merchant-financiers, these bonds were collateralized by mortgages to planters in the Dutch West Indies colonies Berbice, Essequebo, and Suriname.

Mutual funds emerged gradually, as merchants and brokers learned how to expand the range of investment opportunities to the general public during the eighteenth century. The two principal innovations that took place were securitization and stock substitution. Securitization uses the cash flows of illiquid claims as collateral for securities that can be traded in financial markets. In a stock substitution, existing securities are repackaged individually or as part of a portfolio to make them easier to trade, either in smaller denominations or at a lower cost than the underlying claims. Often these innovations were designed to overcome barriers associated with investing abroad, such as foreign registration requirements and the costs of collecting interest or dividends, which prevented smaller investors from participating in securities markets. This broadening of the Dutch capital market eventually led to the introduction of the forerunners of today’s closed-end mutual funds and depository receipts.

Nineteenth-century mutual funds
The first investment trust outside of the Netherlands is the Foreign and Colonial Government Trust, founded in 1868 in London. Like Eendragt Maakt Magt, it invested in foreign government bonds. According to its prospectus, the goal was to provide “the investor of moderate means the same advantages as the large capitalist, in diminishing the risk of investing in foreign and colonial government stocks, by spreading the investment over a number of different stocks.” It was modeled after the Dutch trusts in the sense that investment income was projected to exceed dividends, and excess income would be used to liquidate shares over its projected twenty-four-year life. By 1875 eighteen trusts had been formed in London. It was during this period that the Scotsman Robert Fleming started his famous first trust, investing in U.S. railroad bonds, later named the First Scottish American Investment Trust. During the 1890s, investment trusts were introduced into the United States. Most of the early U.S. investment trusts were closed-end funds, like Eendragt Maakt Magt, issuing a fixed number of shares. The issue of new shares, or repurchases, were not precluded but were infrequent. Moreover, the repurchase or issue price was not necessarily proportional to the intrinsic value of the underlying portfolio.

This changed in 1924, when the Massachusetts Investors Trust became the first U.S. mutual fund with an open-end capitalization, allowing for the continuous issue and redemption of shares by the investment company at a price that is proportional to the value of the underlying investment portfolio. Open-end capitalization has become the dominant model for mutual fund organization, suggesting that it has been an important innovation contributing to its modern success. One cannot fail to be surprised, however, by how many of the features of eighteenth-century investment funds have survived until today.

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