The First Mutual Fund

Vereinigte_Ostindische_Compagnie_bond
Dutch East India Company bond from 1623; Source: Wikipedia

Today the mutual fund industry is a multi-trillion dollar business. It is amazing to think these structures, and other innovations we think of as “modern,” such as asset-backed securities, have their origins in the 18th century.

The material in this post is summarized from an article contained within a 2016 collection of essays, Financial Market History: Reflections on the Past for Investors Today, from the CFA Institute Research Foundation. Specifically, this material is from Chapter 12, “Structured Finance and the Origins of Mutual Funds in 18th-Century Netherlands,” by K. Geert Rouwenhorst.

You really ought to read the whole piece as it contains a wealth of fascinating information not summarized here. If you are the kind of person who is fascinated by the idea of structured finance for colonial plantations, that is.

Anyway, the first mutual fund was launched in 1774 by a Dutch broker and merchant, Abraham van Ketwich. Its name, Eendragt Maakt Magt (“Unity Creates Strength”), goes to show that fluffy marketing copy is as old as the asset management business itself.

Rouwenhorst sets the scene:

The first mutual fund originated in a capital market that was in many ways well developed and transparent. More than 100 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. 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. Equity shares were scarce among the listed securities, 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.

The investment strategy and terms went something like this:

Investment Strategy

The fund’s objective is to generate income through investment in a diversified global bond portfolio.

To achieve its objective, the fund will invest approximately 30% of its assets in plantation loans in the British colonies, Essequebo and the Danish American Islands. The remaining 70% of its assets shall be invested in a broadly diversified portfolio of issuers including European banks, tolls and canals.

The fund shall also conduct a lottery, whereby a certain portion of dividends will be used to repurchase investors’ shares at a premium to par value, and to increase dividends to some of the remaining shares outstanding. (You know, just for fun)

Share Classes

The 2,000 shares of the fund shall be divided into 20 classes, each to be invested in a portfolio of 50 bonds. Each class shall contain 20 to 25 different securities to ensure a diversified portfolio.

Custody & Administration

The investment advisor (Van Ketwich) shall provide a full accounting of investments, income and expenses to all interested parties no less than annually.

The securities owned by the trust shall be held in custody at the office of the investment advisor. Specifically, securities shall be stored in a heavy iron chest that can only be unlocked through the simultaneous use of separate keys controlled by the investment advisor and a notary public, respectively.

Expenses

The investment advisor shall receive an up-front commission of 50 basis points upon the initial sale of fund shares, and thereafter an annual management fee of 100 guilders per class of securities.

Rouwenhorst argues the driving force behind the creation of the fund was investor demand for portfolio diversification. To purchase a diversified portfolio of bonds would have been prohibitively expensive for small investors of the day. These investors may also have been gun shy following a financial crisis in 1772-1773, which nearly triggered defaults by several brokers.

Nonetheless, the fund endured a tumultuous trading history. By 1811 it was trading at a 75% discount to par (!) and was eventually liquidated in 1824, after making a final distribution of 561 guilders. Interestingly, Rouwenhorst notes that the fund actively repurchased shares when they traded at a discount–what looks to be an early form of closed-end fund arbitrage.

I do not have anything especially profound to conclude with here, other than to observe that financial markets have been complex and global in nature for quite some time. The first mutual fund is a perfect example.

Lethal Risk Management Failures: The Battle of The Narrows

For some reason people find risk management boring. I do not understand why. Some of the most influential and fascinating events in history were a direct result of poor risk management. The sinking of the Titanic; the near collapse of the global financial system in 2008; the Ford Pinto’s fuel system. One of the things I find fascinating about catastrophes is that they typically do not follow from a single point of failure—risk management failures are really systemic failures and are therefore worth considerable attention.

I am currently reading a book about the decline and fall of the Ottoman Empire (The Ottoman Endgame: War, Revolution And The Making Of The Modern Middle East (1908 -1923), by Sean McMeekin). The Ottoman Empire controlled Turkey, the Balkans and much of the Middle East and North Africa for several centuries. It entered the terminal phase of its decline (the exact reasons for this are still debated) in the late nineteenth century. The First World War ensured its demise.

Despite this unhappy end the Ottomans achieved some notable victories during the war: preventing the British and French navies from forcing the Dardanelles for one and thwarting the ANZAC landings at Gallipoli shortly thereafter for another. This post is concerned with the first of these military debacles, which I believe has something to teach us about systemic failures and risk management.

This post is structured like a Tarantino film. We will see the outcome first and then explore why things went down the way they did. The date is March 18, 1915. The place is the Dardanelles Narrows (below is a visual). Simply imagine a fleet of British and French warships steaming into the Narrows and you have got the idea.

Dardanelles_defences_1915
Image Source: Wikipedia

Now I will turn things over to McMeekin:

Just past noon de Robeck sent in the French squadron, commanded by Vice Admiral Guepratte, to see what they could do from shorter range. Guepratte obliged with his usual dash, sending the Gaulois, Charlemagne, Bouvet, and Suffren up the Straits, right into the teeth of the Narrows defenses. Now the guns were booming on both sides, with the channel all but choked in smoke and rocked with one detonation after another. At 1:20 p.m., the Bouvet came within range of the Hamidie battery, which rained down fire on the French ship. At 1:50 p.m., Hamidie scored two direct hits from a 355 mm Krupp gun, causing an immense explosion, with a “column of smoke shot up from her decks into the sky.” The Bouvet, listing to her side, then ran over a mine, capsized, and sank within minutes.

[…] Toward 4:00 p.m., the Irresistible had come in range of the deadly Krupp monster gun at Hamidie, which hit her fore bridge and set it on fire. At 4:09 p.m., de Robeck observed that the Irresistible “had a list to starboard”: she had raised a green flag, indicating a serious hit on that side. Though having passed out of range of Hamidie, the then drifted into range of the Rumeli Mecidiye Fort, which rained down shells on her. All the officers could do was evacuate wounded men onto the swift destroyer Wear, which pulled up alongside, and prepare for possible towing.

[…] At 4:11 p.m., the Inflexible, hitherto undamaged, ran over a mine and immediately began to list, down by the bows, in more serious trouble than the Irresistible. Inflexible, at least, was near enough the mouth to limp away from the battle: the Irresistible, having passed up the Asian shoreline into the teeth of enemy fire, was not. Trying to salvage something from the burning, de Robeck sent in HMS Ocean to tow his wounded battle cruiser – only for Ocean, too, to suffer a huge explosion at 6:05 p.m. — leaving both ships helpless under enemy fire at short range.

[…] Doubtless believing the rumors about panic in Constantinople […] Keyes and Churchill seem to have applied them to the shore batteries without thinking things through from the enemy’s perspective. The Turks and Germans, after all, had just witnessed three enemy battleships sink to the bottom under their Straights under their fire from shore; the crippling of the modern, near-dreadnought-class battle cruiser Inflexible; and the rout of the entire French squadron. Over six hundred men had perished on the Bouvet alone, with the British suffering another sixty casualties. By contrast, only three Germans had been killed and fourteen wounded, with Turkish losses scarcely higher, at twenty-six killed and fifty-two wounded—a reasonable price to pay for knocking out fully a third of the invading fleet (six out of eighteen ships).

Bouvet_sinking_March_18_1915.jpg
Image Source: Wikipedia

What Went Wrong

The root cause of this disaster was that allied military planners refused to accept that the Ottomans had the resources, wherewithal or ability to put up this kind of defense.

This was partly a result of poor intelligence. The British did not appreciate the extent to which German military advisors had improved the overall competency of the Turkish officers and soldiers defending the Straights. This is always a risk in war. Rarely does one have perfect information.

The bigger mistake — and one that should have been preventable — was that military planners did not want to believe the Ottomans were capable of such a defense:

Just as they had heard what they wanted to hear in the [Russian] grand duke’s (vague) request for a diversionary strike, so did British policymakers believe what they wanted to believe about the enemy’s dispositions–and fighting capacity […]

[I]n December, Captain Frank Larken, commanding HMS Doris, had subdued the minimal shore defenses of Alexandretta (Iskendurun) simply by showing up in port and getting the Ottoman vali to agree to dynamite two rail locomotives in lieu of bombardment, in a curious face-saving compromise.

The British certainly had experience with more robust Ottoman fighting spirit, during an earlier operation in Mesopotamia (modern day Iraq). McMeekin again:

Shatt-al-Arab was a British victory, to be sure: but it had been a bloody slog, requiring a month to secure a lightly fortified waterway that had been all but abandoned by the Ottomans since Enver was committed to his Caucasian and Suez offensives.

As I see it, British military planners failed to appreciate the risks associated with the Dardanelles operation because they had little incentive to appreciate them. They were engaged in a massive, unproductive slaughter in Western Europe and were eager to achieve tangible results somewhere else on the global battlefield. A direct strike at the Ottoman Empire would serve that purpose nicely. What’s more, because the French were touchy about British military action in certain other parts of the Middle East, options outside the Dardanelles were limited.

Warren Buffett coined the term “institutional imperative” to describe this type of inertia:

In business school, I was given no hint of the imperative’s existence and I did not intuitively understand it when I entered the business world. I thought then that decent, intelligent, and experienced managers would automatically make rational business decisions. But I learned over time that isn’t so. Instead, rationality frequently wilts when the institutional imperative comes into play.

For example: (1) As if governed by Newton’s First Law of Motion, an institution will resist any change in its current direction; (2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.

Institutional dynamics, not venality or stupidity, set businesses on these courses, which are too often misguided. After making some expensive mistakes because I ignored the power of the imperative, I have tried to organize and manage Berkshire in ways that minimize its influence.

So it was with the British in 1915.

Critically, there is no risk management process that can counteract the institutional imperative. As Buffett points out in his 1989 letter, “any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops.” No amount of fact-finding or analysis will help. Only prudent leadership can prevent systemic failures resulting from institutional inertia.

How To Destroy An Economy

FT Alphaville has up a transcript of a fascinating interview with Venezuelan economist Ricardo Hausmann. If you don’t keep up to date on the latest happenings in Venezuela, the below video of a gang of bikers attacking a cargo truck with Molotov cocktails illustrates the post-apocalyptic state of the Venezuelan economy.

And if you have ever wondered how best to blow apart an economy, the interview pretty much walks you through the process. Here is an illustrative passage:

Let me just give you a sense of the magnitude of the mismanagement of the oil industry. In 1998, the year before Chávez got elected, or the year in which in December of that year Chávez got elected and he took power in February 1999. In 1998, Venezuela produced 3.7 million barrels of oil [per day]. Today it’s producing about two. If Venezuela had maintained its market share in the world oil industry — which it could have because it had infinite reserves, it had the largest reserves in the world — it would be producing two million barrels more than it is currently producing. With the same market share. So the collapse is immense relative to history, and it’s immense relative to this opportunity cost of where it should have gone had it just kept its market share the way it was.

That collapse of the oil industry happened in two steps. First, all the know-how of that industry, centuries of man-years of experience was lost in the firing of these people. They were not only fired but persecuted, so most of them left the country. Many of them left the country. And they caused, for example, an oil boom in Colombia [where many of them moved to]. Colombia went from producing 200,000 barrels of oil [per day] to a million barrels of oil thanks to the fact that Venezuelans knew how to extract much more oil from the fields that Colombia was already exploiting.

So there was a massive loss of human capital. They also wanted to create a politically conscious oil company, so they started to put an enormous amount of social programmes and other things on the books of PDVSA, the oil company. And as a consequence they starved the company from investment and they ran the company in an amazingly corrupt way, and this is really not just talk about corruption but evidence of corruption in massive ways. There were these foreign oil companies… These foreign oil companies have been complaining to the government that they want to wrest control of the procurement of oil projects because they know that this procurement is being done at multiples of what things should cost. There’s people that have been found in the US owning hundreds of millions of dollars of money that has been laundered out of PDVSA and so on.

So they really destroyed the hen that laid the golden eggs, at the time when their own plans and their own announced plans was to move Venezuela to produce six million barrels of oil. And instead of increased production they have never been able to stop a very rapid decline in production.

The (understandable) gut reaction of many people to what is happening in Venezuela is to kind of chuckle and shake their heads and say, “that’s socialism for you — good luck with that Bernie Sanders.” However, I’m not so sure the late Hugo Chavez even made a proper go at running a socialist economy. When you read Hausmann’s description of asset expropriations under Chavez it all sounds rather whimsical and Qaddafi-esque:

Chávez won re-election in 2006. And in early 2007 he announced that he was now going to move towards socialism, and he started with a spree of nationalisations. In those days the price of oil was very high, so he could afford to just buy everything that moved or that he fancied.

So for example he nationalised the telephone company that was owned by Verizon. He nationalised the three cement companies that were owned by the Mexicans, Cemex, Holcim and Lafarge. He nationalised one of the largest banks, which was owned at the time by Banco Santander. He nationalised the supermarket chain. He nationalised 3.7 million hectares of land.

So he went on an expropriation spree. At the beginning, when he had money, he would pay for things, and then if these were things owned by people he didn’t like, he would just expropriate and not pay for them. So he changed the contracts of the oil companies in a way that essentially extracted part of the expected cash flows out of them, and many of them accepted but a few of them, Exxon, Conoco Phillips and so on sued. And these suits are now being adjudicated by the International Court for the Settlement of Investment Disputes, and these investment disputes in Washington now add up to $16 billion of claims. Of expropriations that he didn’t pay for. And these are only the foreigners.

He expropriated the service companies that provided services to the oil company, because they started to protest that they were not being paid so instead of paying he just expropriated them.

So he took over significant chunks of the Venezuelan economy, and the typical thing is that the moment they took over a company, they ran it to the ground. Production collapsed. They nationalised the steel company. The steel company at the time of nationalisation was producing 4.5 million tons of steel with 5,000 workers. It now has 22,000 workers but it’s producing something like 200,000 tons of steel. So they ran those companies to the ground. Aluminium is almost not done any more, when Venezuela was producing about a million tons of aluminium back when…

So essentially they expropriated the economy and collapsed it on the public sector. And in the private sector they created all these constraints and this enormous uncertainty over property rights because everybody else was being expropriated and you never knew when it would be your turn. Owens-Illinois was a company making bottles. They were expropriated. Why bottles? Another company making detergents was expropriated. Why detergents?

So everybody else would not know when would his turn come up.

To me that reads more like a dictator and his cronies stripping assets. Which isn’t to defend the merits of socialism so much as argue socialism provided a convenient platform for Chavez to justify the systematic looting of the Venezuelan economy. In fact, dictators in general seem fond of socialist posturing as a means of bamboozling the masses. So-called Arab socialism is littered with examples of strongmen spouting vaguely socialist pronouncements while consolidating political and economic power within single party authoritarian states.

In a serendipitous convergence of themes, the Wikipedia for Nasserism contains the following reference to Chavez:

Hugo Chávez, late President of Venezuela, and leader of the self-styled ‘Bolivarian Revolution’, cited Nasserism as a direct influence on his own political thinking, stating: “Someone talked to me about his pessimism regarding the future of Arab nationalism. I told him that I was optimistic, because the ideas of Nasser are still alive. Nasser was one of the greatest people of Arab history. To say the least, I am a Nasserist, ever since I was a young soldier.”

Empires & Barbarians

Empires_Barbarians.jpgPeter Heather’s Empires And Barbarians is a book worth reading. Unfortunately it is also a book that is difficult to recommend. It is written for an academic audience. Which is another way of saying it can make for incredibly dry reading. This is a shame in that the scholarship, the ambition and the quality of Heather’s arguments are all impressive.

The central idea is this: in the beginning there is agriculture. Primitive agriculture is hard. It consumes a great deal of time and energy and leaves very little time for anything else. Life is nasty, brutish and very short.

What societies need to develop beyond a relatively miserable subsistence level agriculture is specialization.

This can happen in a couple of different ways. One way (the slow way) is that agricultural societies gradually develop technology that makes farming more efficient and less time intensive. This allows certain members of the community to focus on other activities — perhaps the manufacture of consumer goods, or the development of systems of writing (if this process interests you I highly recommend Jared Diamond’s Guns, Germs, and Steel: The Fates of Human Societies). As specialization increases people’s lives tend to get a little less nasty, a little less brutish and a little bit longer.

Another, faster way that development happens is via trade and migration. For example, of early Germanic societies, Heather writes:

In the case of the Germani, Rome may have acted as a source not only of extra economic demand, but also possibly for some of the ideas and technology that made agricultural intensification possible […]

[…] Where and how, exactly, these ideas spread remains to be studied, but both the more efficient ploughs and the better integrated farming regimes were well known in Roman and La Tene Europe, much of which the Empire swallowed up in the first century BC, long before they spread into Germania, and and these areas may have inspired the Germanic agricultural revolution.

Other goods produced in Germania were also in demand in the Roman world. The occasional loan word and literary reference identify some specific products. Goose feathers for stuffing pillows and particular kinds of red hair dye were two such items. Much more important than any of these, though, was the demand certainly for two, and probably three, other raw materials.

Empires And Barbarians is more or less a case study of migration and development in the context of Europe in the first century AD. What I take away from the book is not so much the details, but the timeless nature of the process.

For example, in the fourth and fifth centuries the arrival of the Hunnic Empire in Europe caused enormous political and social dislocations. In essence, displaced barbarians showed up on the Roman Empire’s doorstep. For a whole series of complex reasons, not least of which was the need to bolster Roman Legions with barbarian manpower, the Romans were sometimes forced to grant concessions.

In a general sense, this is not so much different from what we see in Europe today with the mass influx of refugees from the Middle East, North Africa and South Asia. Or in the United States with refugees and migrants from Central and South America.

Again, Heather:

[I]t is important to factor in the general patterns of economic development operating in and around the Roman world. The Goths and other Germanic migrants of the third century had moved into the Black Sea region because it was part of a more developed inner periphery around the Roman Empire, with many economic attractions. And while these migrants were benefiting from that greater wealth, the Roman Empire was operating at a still higher level of development, with still greater economic surpluses. This wealth was immediately visible to outsiders in the Empires frontier zones in the form of towns, fortifications, armies, even villas, all of which, as we have seen, regularly attracted cross-border raiders. Ammianus’ account of Gothic motives, — that Roman wealth had entered their calculations — makes perfect sense, therefore, and also recalls modern case studies, where it is rare for economic motivations to be absent from immigrants’ calculations, even when their thinking has a strong element of the political and involuntary about it.

What I think is often missed in the debate surrounding immigration and refugee policy is this “zoomed-out” perspective of trade, migration and development. This is not some series of isolated incidents that can simply be prevented or outlasted. It is a cyclical process underpinning the evolution of human civilization. You don’t “beat” these kinds of cycles any more than you “beat” waves in the ocean.

So why does this get missed?

The news cycle plays out in hours. Election cycles play out in months and years. Economic cycles play out over decades. These cycles of migration and development play out over multi-decade, multi-generational time horizons. They create winners and losers.

People do not like to spend even half a lifetime losing. They will do seemingly crazy things to stop losing — to have a shot at winning. They will vote dictators into power. They will support ill-advised wars of aggression. They will wander thousands of miles on foot and pay thousands of dollars to criminals to ferry them across oceans in what are more or less bathtubs.

The value of a history like Empires And Barbarians, dry as it may read at times, is that it can afford to take the very, very long view. A luxury we cannot often afford.