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.
When we combined all the factors together, we saw the link between asset growth and the degree to which a fund changed. Income Fund of America
Of course, the pink elephant in the room is Growth Fund of America
To few a table of our results, please click here.
Putting It All Together
Asset growth has led to changes in the measures we're looking at, but that doesn't mean that the fastest-growing funds change the most. Plus, investment judgment may also help to explain modifications in style. It isn't easy to identify the degree to which changes in market cap, for instance, have been driven by a shift in valuations rather than by a flood of inflows. What will happen several years down the road, when large caps trade at a premium to small, remains to be seen. If these funds continue to attract assets and smaller stocks begin to look more attractive, they won't have the flexibility to move down the market-cap ladder.
We also worry about the funds we mentioned that have picked up more stock holdings. Unlike a hike in market cap, this is clearly driven by asset growth. This practice dilutes each stock's impact on the fund's performance. American's steps to add more people should help. With assets increasing by about 12% per year since the beginning of the decade and new hires coming in at a 6%- to 8%-per-annum clip, it seems that folks will have to work on more ideas than they had been a few years back.
We don't see impending disaster for American's funds, but some are losing a bit of their character and may have more marketlike returns as they add more managers and the managers add more stocks. Although we've pared back some American Funds from our Analyst Picks list, we still have a number of them there because we think that their low costs, sound management, and mild risk profiles will enable them to produce pleasing risk-adjusted returns in the future. Others like Growth Fund of America have been removed from the picks list because of their extreme asset growth and the fact that they are more focused on returns than risk.
Paul Herbert is a senior analyst with Morningstar.
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