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Long-Term Ethos Helps American Funds

It gets an edge from sticking around.

John Coumarianos, 12/30/2008

Many fund managers say they buy stocks for the long term, but in reality, they rarely stick with a company for long. The typical mutual fund turns over 83% of its portfolio annually, suggesting a holding period of about 14 months. At the American Funds, however, the average rate of portfolio turnover for its funds is 29%, so the firm's managers usually stick with a stock for more than three years. This month, I'd like to focus on American's less-frequent trading and portfolio turnover because I think it constitutes a significant part of the firm's edge over its competition.

Why Funds Trade
First, low turnover, by itself, probably isn't a competitive advantage because nothing prevents other investment organizations from copying it. Similarly, managers are not forced to churn the stocks in their portfolios. After all, it's not as if portfolio managers go to work each day and are required to buy and sell stocks.

But there are powerful incentives in place that may encourage a manager to trade. Many managers' bonuses are computed on the basis of their shorter-term performance: say, one, two, or (at best) three years, or some combination thereof. In fact, only about half of the fund companies we analyze for Morningstar's Stewardship Grades for mutual funds pay their fund managers primarily based on performance over periods longer than four years. By emphasizing shorter-term performance periods, managers are less likely to think of themselves as long-term investors or business owners; instead, they're compelled to try to capture shorter-term movements in stocks. Managers more interested in short-term price movements of stocks than longer-term business prospects are naturally discouraged from buying out-of-favor stocks. Even if their analysis shows the stocks are cheap relative to the longer-term value of the underlying businesses, the stocks may not turn around quickly enough to personally pay off for the fund manager.

So, instead of buying low and viewing further price declines as still-better buying opportunities, managers avoid stocks that seem like problem children. Managers with short-term performance goals want to buy what's "working," and what's working changes on a day-to-day, if not a minute-to-minute, basis. As a result, managers don't invest slowly and methodically, but trade haphazardly and sometimes frenetically, with their annual bonus on the line.

There may even be something about a mutual fund's structure, including its daily pricing and liquidity features, that encourages fast trading. For example, I recently heard a fund manager say that he and other managers were judged on a weekly and even daily basis. While it's true that daily pricing makes it possible to judge funds against each other on a weekly and daily basis, it seemed to me as if the daily pricing feature of funds encouraged him to judge his own performance according to an unrealistic time frame.

Short-term incentives also cause managers to construct portfolios that look very similar to indexes in the hopes of squeezing out slight consistent victories over most of their competitors or the index. In a rather tepid attempt at differentiating themselves, managers will own stocks that are leaders in a major index even if they're not bullish on the company, but they'll own the stock in a lower proportion than their index weighting. Managers will also trade "around" positions, alternately boosting them and decreasing them relative to the index and their peers based on short-term expectations and liquidity because they're fearful of underperforming for a quarter or a year. In effect, they sacrifice the attempt to excel over the longer haul to achieve tiny gains every quarter.

Tiny, consistent gains can add up, but they usually don't materialize from this effort. What's important to professional managers, however, is that big relative losses don't materialize either. As long as a manager looks roughly like the index and his peers on a consistent basis, his job security stays intact. And there you have the warped ethos of most professional investors: The biggest sin--and the surest way to be handed a pink slip--isn't modest long-term underperformance compared with an index or your peers but radical short-term underperformance that results from looking substantially different from the index or your peers.

How American Discourages Turnover
So, if short-term thinking encourages a kind of built-in bias favoring turnover, what can break the bias? Why is American different? One easy way to break the bias is to impose a bonus system based on a longer-term performance time frame, and this is exactly what American has done. The bonuses of American's investment professionals are based on four-year performance results. Second, the firm encourages collaboration by having parts of the bonus based on the overall performance of the organization. Even if absolute performance is down, bonuses can increase if American's funds outperform relevant indexes and peers over longer time frames. Third, according to Charles Ellis' book Capital, American's employees have nearly $1 billion of their own money invested in their defined-contribution plan, which consists of the same retail funds that 20 million shareholders own; American's employees eat their own cooking. Fourth, ownership in Capital Research by many of its investment professionals also provides long-term incentive. According to Ellis, more than 350 people have an ownership stake in the business and are, therefore, concerned with its long-term success. All of these factors give American fund managers (and even rank-and-file employees) plenty of incentive to act with long-term results in mind.

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