Some American Funds Insiders Said Size Was a Problem

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:

• AMCAP AMCPX portfolio counselor Barry Crosthwaite said in his survey that the "funds are getting so large that it becomes more difficult to execute mid-cap stock ideas"
   
• Counselor Dale Harvey remarked that Capital should "[c]lose all the funds. Don't just close the biggest or fastest growing. Doing that would simply shift the burden on to other funds. Keep them shut until we figure out the new unit structure and relieve the pressure of PCs managing $20 billion." Harvey, who ran parts of Investment Company of America AIVSX, American Mutual AMRMX, Washington Mutual AWSHX, and SmallCapWorld SMCWX, later complained that portfolio counselors weren't sharing investment ideas and were unable to buy analysts' and others' best ideas because the firm had bumped up against the SEC's ownership limits. "People are hoarding ideas," he wrote. "There's less debate."
   
• Other investment professionals expressed concern that funds were directing cash to securities that were "marginal ideas" or where "there is limited conviction."
   
• "What are the major issues facing CRMC today: Size, Size, Size, and Size in that Order," wrote Taylor Hinshaw.

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.PAGEBREAK

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.