How Will the American Funds Fare in 2008?

A version of this article appeared in the December issue of Morningstar's American Fund Family Report, our monthly newsletter dedicated to helping American Funds investors find superior long-term investment opportunities. Follow this link to review a risk-free trial issue.

Each year, the American Fund Family Report reviews what the editor expects from the stock and bond markets in the coming year, and doles out advice on the American Funds based on those views. The idea is not to make sweeping calls and tell readers to dramatically restructure their own or their clients' portfolios in an attempt to capture short-term trends. Instead, these are ideas for tweaking and rebalancing a portfolio as conditions and funds' prospects change.

I'll start by reviewing the predictions my predecessor Paul Herbert made in the December 2006 issue, and then I'll discuss my thoughts about potential investing opportunities in 2008. I think investors can benefit from reviewing their own portfolios at least annually to see how their previous assumptions about the markets worked out. I also believe it's healthy to adopt a contrarian perspective when assessing your portfolio and to remember that many trends eventually revert to the mean. Certainly, a contrarian approach isn't always going to work; there are times when trimming your holdings in a hot asset class or sector hurts over the short term. But this attitude can help you avoid getting caught up in manias that tend to burn those who jump in late--or load the boat near the end--expecting past trends to continue indefinitely.

Domestic-Stock Picks--2007
In 2005 and 2006, one of the recommendations this newsletter made was to tilt your portfolio toward large-growth funds, which had dramatically lagged their large-value counterparts since the tech bubble peaked in early 2000. (Before taking over the newsletter in March, I took a similar stance in my own work for Morningstar.) And while large-value funds continued to outperform through 2006, that trend reversed in 2007. All three of American's large-growth funds--Amcap AMCPX, Growth Fund of America AGTHX and New Economy ANEFX--outperformed each of the firm's large-value offerings (American Mutual AMRMX, Investment Company of America AIVSX, and Washington Mutual AWSHX) in 2007.

There are multiple reasons for this reversal. First, the credit crunch kicked off by issues among subprime mortgages caused the financial sector--a favorite of large-value skippers--to tank. Second, over the past seven years, the valuations of many companies that fall in the value camp simply converged with those of companies that generate higher earnings growth, and investors apparently recognized that.

But although this newsletter's take on large growth proved correct in 2007, owning Amcap over its two category siblings didn't work out--it has actually lagged Growth Fund and New Economy. We've liked Amcap because it has more of a pure focus on large, steady growers--thus, it ought to perform best when growth bounces back--and its holdings were more attractively valued, on average, according to Morningstar's equity analysts. However, as many value stocks have faltered, investors have turned not to behemoths with dependable profit growth, but to faster growers with relatively high price multiples. And they also have stuck with energy stocks (another value-oriented sector), which have continued to soar. These trends pushed New Economy and Growth Fund of America ahead of Amcap. Among American's large-value choices, Washington Mutual was recommended on the basis of its holdings' more attractive valuations: It outpaced American Mutual in 2007, but lagged Investment Company. It's also worth noting that the best performers among the firm's domestic-stock funds generally had more exposure to foreign stocks, which benefited from the continued fall of the U.S. dollar against other major currencies.

International-Stock Picks--2007
Although our domestic-stock recommendations didn't score the biggest gains, folks who followed our advice and stashed more money in overseas stocks ended up doing well. That's a recommendation the newsletter's editors have repeated for a couple of years, as U.S. investors have often held a paltry stake in foreign stocks. EuroPacific Growth AEPGX has been our favorite pick, primarily because it's American's only fund that invests exclusively in non-U.S. stocks, and it has continued its recent streak of fine absolute returns. The fund gained 19% in 2007--nearly two thirds more than the shop's best-performing domestic-equity fund, Fundamental Investors ANCFX. American's global funds also performed quite well in 2007.PAGEBREAK

Fixed-Income Picks-2007
We were wary of taking too much interest-rate or credit risk in 2007. Thus, we favored Short-Term Bond Fund of America ASBAX and Intermediate-Term Bond Fund of America AIBAX over more-adventurous sibling Bond Fund of America ABNDX. The latter fund tends to sport a longer average duration--a measure of interest-rate sensitivity--and a bigger stake in midquality corporate bonds. Although a similar stance going into 2006 didn't fare well, the aforementioned credit crunch weighed on lower-rated bonds in 2007. So Bond Fund of America lagged the other two in 2007 (about 1.8 percentage points behind Intermediate).