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Three Lessons about the American Funds

Read on for some key insights into the big fund family.

Paul Herbert, 01/03/2007

Below is an article from the November issue of the Morningstar Fund Family Report on American Funds, our monthly newsletter dedicated to helping American Funds investors find superior long-term investment opportunities. To review a risk-free trial issue, click here. Fund Family Reports on Fidelity and Vanguard are also available.

All figures are as of November.

In recent months, my Morningstar analyst colleagues and I have had several worthwhile conversations with portfolio managers and others at Capital Research & Management Co., the advisor to the 30 funds in the American Funds lineup. Here I want to share some of what I think are the most important takeaways from these meetings for investors in these funds.

1. Asset growth remains a key concern, the firm's arguments notwithstanding.
The folks at American Funds continue to bristle at my suggestion that large funds such as Growth Fund of America AGTHX, which now stands at $156 billion in assets, could run into some trouble because of their large size.

Most of the push-back centers around three ideas. First, the firm says it has long been planning for the growth it has experienced in recent years. For example, the multiple-manager system, which has been in place for decades, safeguards against the harm that can result from individual managers running too much in assets. Second, Growth Fund's recent record proves that size isn't a hindrance. Third, closing funds--I have suggested that CRM at least examine shutting off access to Growth Fund in the past--is overrated because the typical closing doesn't slow asset growth by very much, and there's evidence that funds underperform after closing.

For the most part, I'm unimpressed with these arguments. In regard to the firm's first assertion, that it has long been planning for huge asset growth, it may be reasonable to assume that, because of the firm's multimanager structure, individual managers at big American funds aren't running as much as the bosses of bulky funds from other shops such as Fidelity and Vanguard. But we can't verify that assumption. American doesn't disclose how much individuals are running, even though other firms provide this information in their funds' Statements of Additional Information filed with the SEC.

Spelling out this information seems to me to be an obvious way to convince people (including me) that the funds' girth is under control.

Second, although Growth Fund's performance has been outstanding, we've noticed other growing funds deliver strong short-term showings, perhaps because putting new money into existing positions drives up the prices of these securities. It's a slowdown in long-term performance that's more of a concern.

I'll admit that American may have a point on closing funds. Our own work on offerings that have drawn the shutters indicates that funds with a big presence in the 401(k)-plan market often don't see much of a slowdown in asset growth after closing (because new plan participants can send money postclosing). I think it's more important to remember that fund companies have latitude when it comes to the methods they use to restrict asset growth. Firms that know the composition of their shareholder bases and where the money is coming from should be able to shut down in a responsible fashion.

In all, I'm still worried that the funds' continued growth will end up eroding their performance records.PAGEBREAK

2. Dividends are in the manager's DNA.
While the importance of dividends to American Funds' modus operandi has been apparent to me for a long time, my understanding of dividends' place in the managers' stock-selection process has become fuller in recent months. At least a couple of managers from American Funds have explained the role of dividends in a very useful way in recent interviews.

Dividends have a crucial role in growing wealth, because if reinvested, they can add to the total returns of a fund (or an investment, generically). More than 40% of large-company stocks' 10.4% annualized gain from 1925 to 2005 can be attributed to reinvested dividends. It's staggering how much reinvested dividends have added to the returns on funds such as Washington Mutual Investors over time: $10,000 invested in the fund in 1952 would have been worth more than $6 million in 2006 if dividends were reinvested. Failing to plow that money back into the fund would result in an ending balance of just more than $830,000. That's a serious difference.

But that's not the only reason managers at CRM emphasize dividends. They want to own stocks for the long haul, and one thing that will help them to discover if a company deserves a lengthy commitment of capital is the strength of its CEO's pledge to long-term wealth creation. Dividends can help in that effort. CEOs have to make choices about what to do with a company's extra cash. Many use that money to buy back the company's shares or make acquisitions. These steps can help to boost a company's earnings per share but don't return cash directly to the firm's stock owners the way that dividend payments do. American's managers would rather invest with company executives who see stock owners as partners, and the existence of dividends gives them a better idea that they're dealing with company managers whose interests are aligned with theirs.

I think this income orientation is important because it helps the managers to find superior long-term holdings for your funds' portfolios.

3. New funds are not anathema at the big fund shop.
I thought it was big news when American disclosed in July that it was launching Short-Term Bond Fund of America, the firm's first new mutual fund since 1999. But that was before the announcement in November that the firm was about to launch nine new funds for the retirement market. In early 2007, companies will be able to automatically enroll their employees in 401(k) plans. Pension-rule changes earlier this year stipulate exactly the kinds of funds that will serve as default options for new 401(k)-plan investors, and American's offerings did not qualify.

To avoid getting kicked out of plans, the firm is launching a series of target-date funds to play this role. It will be interesting to see how CRM structures these portfolios, which will launch Feb. 1. Some firms' target-date funds have been very successful in attracting assets, which can be problematic because these vehicles are typically made up of other, sometimes larger, funds in a firm's lineup. If Growth Fund or some of the other large American funds end up in these lineups, they could be dealing with a lot more inflows.

Paul Herbert is a senior analyst with Morningstar.

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