Some American Funds Insiders Said Size Was a Problem
Lawsuit evidence shows some portfolio counselors voiced concerns in a 2004 internal survey, but the funds' strong performance is hard to fault.
Some Morningstar analysts, including me, have long speculated that the billions in American's funds are more of a minus than a plus. An internal survey that American Funds parent Capital Research and Management gave to its employees, including portfolio counselors and analysts, in late 2004 revealed that there has been internal debate about the size issue and that many of American's own employees at that time thought the firm's size was a problem.
The Court Case and the Survey
Portions of the employee survey were released as part of an excessive fee suit (In re American Mutual Funds Fee Litigation (C.D. Cal. 2009)) brought against Capital Research and Management Company, advisor to the American Funds. On Dec. 28, 2009, Capital Research won a decision in federal district court. District Court Judge Gary Feess sided with Capital Research, indicating that the plaintiffs didn't meet the burden of proof.
During the trial, the plaintiff's counsel submitted evidence from the survey. Of course, as lawyers for the plaintiffs, it was their job to diminish Capital's credibility, so they submitted a raft of damning quotes. Still, the quotes show that at least some of the firm's portfolio counselors were concerned about the funds' size.
Capital executive Tim Armour told the court that around 100 surveys were sent out, 70 or 80 of them completed, and one-third of them contained concerns about the size of the funds and the amount of money Capital was managing. In a recent conversation with Morningstar, Armour also noted that most of the comments critical of Capital's size came from analysts who hadn't been at the firm very long.
Here's a sampling of some of the more critical quotes:
American at a Crossroads
To put these quotes in proper context, it's important to note when the survey was taken. In early 2005, American Funds had just wrapped up its peak year in flows; for the calendar year 2004, the firm took in a whopping $86 billion. Given that backdrop, it's understandable if some portfolio counselors grew frustrated with the sheer velocity of the inflows.
American, however, was big long before 2004, and the funds remain so today even after their assets shrank 28% to $934 billion following redemptions and market performance in 2008 and 2009. Growth Fund of America's (AGTHX) and Washington Mutual's top-25 holdings are large enough to comprise more than four days' worth of average trading volume for each stock. This means it would take the firm 40 trading days to exit a position if it soaked up 10% of the position's trading volume every day. A look back to the 1995 portfolios of these funds, however, reveals roughly the same position sizes relative to trading volume.
American has managed its growth in a number of ways. First, its funds are run by dozens of managers who each independently run a distinct sleeve. This model allows the firm to add more managers as assets grow. Second, Capital has split its investment operations into distinct groups based primarily on feedback from portfolio counselors and analysts. Its institutional money-management arm, Capital Guardian, split from Capital Research in 1990, and shortly after the survey was taken, Capital Research split into Capital World Investors (CWI) and Capital Research Global Investors (CRGI). The funds are now run by two advisors with similar but separate investment processes.
American's decision to spread billions of assets across multiple managers has some parallels in the fund industry. Fidelity runs its institutional and retail assets separately, while Vanguard divides its fund assets among several different subadvisors.
As an organization, Capital deserves credit for having a debate over how to manage its size and for having a corporate culture where dissenting opinions are sought out and dissenters feel safe in making potentially unpopular comments.
Capital's best answer to these charges of asset bloat is the performance of the funds. In the five years since the survey was conducted, all of American's equity funds have outperformed their respective category averages, except for New World.
However, that fund's large stake in developed market stocks has held it back versus its riskier competitors, but it has handily outperformed a custom benchmark that more accurately reflects its strategy.
American's five domestic equity funds with 33-year records look good, too. We went back that far, eliminating New Economy (ANEFX) and Fundamental Investors (ANCFX), which didn't exist in 1977, because that was the first full calendar year of the Vanguard 500 Index Fund (VFINX) allowing individual investors to access a no-load, low-cost index-tracking fund (see table below).
|Name||Return (Day to Day)|
01-01-1977 to 12-3-2009 USD
|American Funds AMCAP A||13.17|
|American Funds Washington Mutual A||11.71|
|American Funds Growth Fund of Amer A||14.36|
|American Funds Invmt Co of Amer A||11.80|
|American Funds American Mutual A||11.60|
|Vanguard 500 Index Investor||10.43|
After fees, the index fund produced a 10.4% annualized return from the beginning of 1977 through the end of 2009, while an average of the five American funds produced a 12.5% annualized return, outpacing the index by 2.1 percentage points over the 33-year period. All of the American Funds produced higher annualized returns than the index fund.
Growth Fund of America posted the best return, with a 14.4% annualized gain, and American Mutual the weakest, with an 11.6% annualized gain. American's counselors have indicated that they think 1.5 to 2 percentage points of outperformance per year is a respectable return for active management. By their own standard, they have succeeded collectively, size and all, though not individually with American Mutual, Washington Mutual, or Investment Company of America, which produced 1.2, 1.3, and 1.4 percentage point annualized victories over the index for the 33-year period.
Counting in American's favor is American Mutual's income component; plus, it is rarely, if ever, fully invested in stocks.
Finally, over the 33-year period, the five domestic stock funds produced quarterly eight-year rolling returns that exceeded those of the Vanguard 500 Index Fund an average of 64% of the time. The difference, however, was significant, with Investment Company of America surpassing the index in 74% of the rolling periods and American Mutual surpassing it only 52% of the time. Again, however, American Mutual's more conservative profile absolves it to some extent from seemingly middling results.
It's difficult to quibble with the American Funds' risk-adjusted returns, and it shows that the firm has effectively managed its size so far. Still, there's no doubt that size has an impact on the funds' ability to build and exit positions. For example, Oracle (ORCL) is a stock held across a few of the funds. According to SEC filings, the funds collectively owned almost 500 million shares, which is about 18 times the stock's average daily volume. American portfolio counselors have told Morningstar that they could claim about 30% of a stock's average daily volume. Under that assumption, it would take the funds about 60 days to exit Oracle. To add a few more examples, it would take the firm around 30 days to dump its holdings in Target (TGT) and roughly 60 days to exit Merck (MRK).
Size issues become more pressing the further you move down the cap ladder, and that could be one of the factors behind SmallCap World's lackluster results. While the fund has outperformed its category, its small-cap strategy makes it an odd fit among its more larger-cap world-stock category peers. Its 10-year returns fall well short of the S&P Global Less than $2 Billion Index, a benchmark that more accurately reflects its strategy.
So while American has capably managed its growth up to now, there are limits to what it can do at its current asset size. Its girth impacts how and what stocks it trades, and limits the funds' capacity to traffic in smaller and less liquid stocks. Consequently, the firm's sweet spot is likely to remain in the larger-cap strategies.
While the size issue bears monitoring, American's long history of good stewardship and their ability to manage their size so far at least inspires some confidence. It may be too much to expect dramatic outperformance versus the index at this point, though.
Morningstar Fund Analysts Ryan Leggio and Sonya Morris contributed to this piece.
Readers: Are the revelations of the court case making you reconsider your investments in the American Funds? Please feel free to comment below or share your thoughts with me at firstname.lastname@example.org
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John Coumarianos does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.