Why success could spoil American Funds
Money keeps pouring into its top performers. But how many good investment ideas can one company have?
(Money Magazine) -- No one used to talk much about American Funds. The Los Angeles investment firm that manages the group, Capital Research & Management, preferred to let a stellar record speak for itself.
But with great returns come greater piles of cash, to the point that American Funds has vaulted past index king Vanguard to rank as the nation's largest fund company. It runs six of the 10 biggest funds, including No. 1, Growth Fund of America, which tips the scales at $146 billion - more than the combined assets of Fidelity's two giants, Contrafund and Magellan.
Now everybody is talking about American Funds. With fame and fortune comes a question: Has the company grown too big for shareholders' good? When funds balloon, managers have a hard time keeping up performance because size lessens the impact of any one winning investment.
American Funds offers just 29 portfolios, and since it almost never closes a fund to new investments, each has become a behemoth. "We've never seen this kind of asset growth at one company before," says Roy Weitz, head of FundAlarm.com. "It's hard to see how they can continue to handle that growth indefinitely."
The folks at American Funds, of course, disagree. "Our investment management system is designed to handle large assets," says Drew Taylor, Capital Research's manager of analytical services.
He's got a point. Funds are assigned several managers; each is responsible for a chunk of the portfolio and chooses stocks independently. So far the strategy has held up well. More than two-thirds of the funds rank in the upper half of their categories since 2001, including Growth Fund of America, which beat the S&P 500 by nine percentage points in 2005.
Better Than an Index?
Yet there are signs that the Cap Research system is reaching its limits. In a recent study, Morningstar analyst Paul Herbert found that the group's stock funds have delivered more index-like performance over the past five years. "Many are still producing market-beating returns," says Herbert, "but overall they are showing much higher correlations to their benchmarks than before."
To be fair, that's partly because the low-priced stocks that American Funds holds have done well and so are now a bigger chunk of broad indexes. Still, the more closely these funds track the indexes against which they're measured, the less sense it makes to buy them. You often pay a 5.75% broker commission to invest in an American Funds offering. Yet you can buy an index fund that deliberately tracks a benchmark and that has super-low annual fees and no sales load.
There's also evidence that asset growth is weighing on the group's small-cap and emerging markets funds, which hold thinly traded stocks. Capital Research has become the largest owner of many companies, so it's difficult for managers to trade those stocks without driving prices up or down and damaging returns. That, says Herbert, is one reason $18 billion Smallcap World actually keeps only 32% of its portfolio in small stocks, compared with 60% four years ago.
Still Got an Edge, but...
None of this means that American Funds is about to fall off a cliff. The group's research-intensive strategy and low operating expenses make it the best of the broker-sold fund families.
That's why three American Funds stock fund offerings - American Mutual, Amcap and EuroPacific - remain on our MONEY 65 list. Still, at this point you should rethink the role that American Funds plays in your portfolio.
IF YOU BOUGHT TO BEAT THE MARKET, YOU'RE IN THE WRONG PLACE These funds have never aimed to shoot out the lights. American Funds' type of value investing may be in style today, but investing fads change, and no fund group has shown it can stay on top indefinitely. Remember when Janus was the king of growth investing in the 1990s?
DON'T GO ALL-AMERICAN Owning several funds from a single family can limit your diversification. And many American Funds portfolios have not only the same stocks but the same managers.
In a tax-deferred account, hold on to your American Funds investments but consider moving some money to other fund groups. In an account where selling might trigger a taxable gain, direct new contributions elsewhere.
STICK TO THE CORE Since small-cap and emerging markets funds are hurt most by asset growth, look to other fund groups for choices in these categories. For large-cap funds, heft may slow you down a bit, but it won't kill you.