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October's Mutual Fund Red Flags

Do changes spell trouble for these three American Funds?

Paul Herbert, 10/24/2006

This article originally appeared in Morningstar FundInvestor, an award-winning newsletter that presents investment strategies and tracks 500 funds.

Red Flags is designed to alert you to funds' hidden risks. Such risks can take many forms, including asset bloat, the departure of a solid manager, or a focus on an overhyped asset class. Not every fund featured is a sell, and in fact some are good long-term holdings. But investors should be prepared for a potentially bumpier ride in the near future.

Related to our feature article this week in Investment Insights about asset bloat and American Funds, we're flagging three funds from American because their portfolios have undergone significant structural changes during the past five years. Managers of growing stock funds face higher trading (or "market-impact") costs because their transactions compose more of each stock's volume.
 
The bosses at American have tried to deal with these costs by beefing up their investment staff, which should help to split trading decisions among more people. Still, it's clear that the funds have changed in other ways, by adding holdings and flocking to larger stocks (because a greater number of their shares regularly exchange hands). Such alterations may make it more difficult for the funds to trounce their peers and benchmarks the way they have during
the past few years. Plus, for most offerings, we've also seen an increase in performance overlap with the S&P 500 Index, as indicated by higher five-year R-squared figures.

The case for flagging the funds listed below isn't cut-and-dried. For all of our cautious tones on asset bloat, we can't point to a rock-solid cause-and-effect relationship between large or growing asset bases and the erosion of excess returns. Besides Fidelity Magellan and perhaps one or two Janus funds, bigger large-cap funds tend to hold up just fine after becoming stuffed. Then again, we also haven't seen any funds with such large asset bases that have experienced such quick and dramatic growth as we have at American, which makes us wonder if our past experience is really much of a guide when we examine the funds' prospects.
 
Overall, these funds are not "sells." In fact we think there are compelling reasons to continue to recommend them for the most part. We just think they've changed enough that you should consider whether they still fill the same role in your portfolios.

American Balanced ABALX
American Balanced, a moderate-allocation fund, showed the second-biggest percentage jump in equity assets within the firm--we looked at equity assets because size problems don't seem to affect bond allocations--and the biggest percentage increase in average market cap. It tied with large-value American Mutual AMRMX for the largest increase in five-year R-squared. At $69.6 billion, American Balanced's average market cap as of mid-2006 was the highest in the American Funds' lineup by about $10 billion. That positioning sets it up for glory if the biggest stocks reclaim market leadership. When smaller stocks start looking cheap again, however, the $53-billion fund may be hard-pressed to add to such fare.

Capital Income Builder CAIBX
This world-allocation fund has grown more than any other fund in American's lineup in percentage terms and has really spread out its bets during the past five years. It held just 115 stocks in mid-2001, but that number had grown to 255 as of this past June. Why does it hold so many stocks? Though its stake in middle-sized fare has shrunk lately, its managers like to devote a percentage of the fund to mid-cap stocks. And they can't take very large positions in individual names in that cap band because the fund's asset base is $71.7 billion.

A position that took up 1% of its assets would represent more than 10% of the market capitalizations of a great number of mid-caps.
 
Growth Fund of America AGTHX
This fund's portfolio hasn't changed that much relative to the others in the lineup on the measures we considered, despite adding $114 billion in equity assets from the middle of 2001 to 2006's halfway point. That may be good news for its prospects. Still, we think there's reason to be wary here because growth funds have to retain a fair amount of flexibility to find tomorrow's Microsofts and Googles--and that's a meaner feat for a $147 billion vehicle.

Paul Herbert is a senior analyst for Morningstar.

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