Which funds in the family show signs of strain due to assets.
This article originally appeared in Morningstar FundInvestor, an award-winning newsletter that presents investment strategies and tracks 500 funds.
American Funds' asset growth has been breathtaking. The firm was running an estimated $333 billion in assets as of the end of December 1999, and that sum had grown to about $859 billion by the end of July.
Despite that asset growth, American's funds have largely performed well. We set out to see which are showing signs of strain due to assets.
Asset growth can be a problem because it can drive up trading costs or force a manager to change his strategy in order to avoid letting trading costs soar. American Funds' advisor, Capital Research and Management, has been tackling the problem by adding resources. Specifically, it distributes funds' assets among more managers and has hired more analysts. CRM is also in the midst of a years-long effort to divide its investment staff into two separate parts to make decision-making more diffuse.
On the portfolio-management side, there are three common tactics for handling growth: holding more cash; owning more stocks; and choosing bigger stocks, which have more volume. Why should you be concerned if a fund makes one of these moves? The fund may not play the same role in a portfolio if it has moved up the market-cap ladder or drastically altered its asset mix. More importantly, it may not be able to keep up its winning ways.
Do any of the American Funds appear to be in danger of losing some ground because of such size-driven strategy tweaks? To find out, we looked at the number of holdings and average market cap for each equity fund as of June 30, 2006, and as of the same date in 2001. Much of American's growth has come since 2002, so using these start and end dates should give us a reasonable idea of how new money has impacted the funds' profiles.
We looked at each fund's R-squared, which measures how much of its returns over a certain period of time can be explained by those of a market index. We looked at each fund's change in its five-year R-squared relative to the S&P 500 Index, using end dates of Aug. 31, 2001, to Aug. 31, 2006. After looking at the change in each factor--number of holdings, average market cap, and R-squared--we also came up with a combined change score for each fund.
We found that American's funds have seen sizable increases in the number of stocks and in R-squared. For example, Capital Income Builder, which has seen its equity assets grow by more than $50 billion in five years, has more than twice as many stocks as it did five years ago. We looked at equity assets and stock holdings for all funds, because for the most part it doesn't become much harder to trade bonds as assets come in. Growth Fund of America, Amcap, and Income Fund of America also had large increases in holdings. Of this group, each showed tremendous growth in its equity assets, except for Amcap.
Increases in market cap and R-squared could be attributed to other factors, at least in part. For one, value funds and value-leaning allocation funds showed the largest increases in average market cap. This upward creep is consistent with what we've been hearing from managers everywhere: After years of strong performance from small- and mid-cap stocks, value hounds are finding bargains among the largest stocks. So, it's tough to separate how much of an increased R-squared was due to manager choice and how much was forced by asset growth.