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How to Handle Three Strong Performing American Funds

What should you do if you own one or more of these sizzling funds?

Paul Herbert, 10/16/2006

Below is an article from the August 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.

Returns and asset figures reflect the most-recently available information as of early August.

A couple of months ago, I wrote a piece in the newsletter about whether it was a good idea to buy, sell, or hold the three American funds that have been trailing their Morningstar categories during the past several years. My aim was to remind readers that it isn't always a good idea to sell weak performers or, in the case of New World NEWFX, to point out that a fund's absolute returns are often more important than its percentile rankings.

This time around, I'll review offerings from American that have really shone recently. Why would you want to change your stance on one of these star performers if you already own one? Because while it may seem natural to assume that a hot streak is evidence of staying power, a run of great performance could instead indicate that a fund's valuations are on the high side and that the securities in its portfolio could be due to cool off. For instance, during most of this decade, funds that have preferred riskier stocks and bonds--including small- and mid-cap stocks, high-yield bonds, and securities with revenues closely tied to commodity-price movements--have usually prospered.

Current valuations rely on a continuation of all of the trends we've seen in the recent past, though, which may or may not transpire.

How do you separate funds that will continue to post strong results from those that could be pricey and may have had too much of a helping hand from the market's passing preferences? By delving into specific elements of funds' portfolios, and, in particular, by paying attention to how they have been approaching the lesser-quality investments that have been soaring recently. Plus, because the funds discussed below have been the lineup's best relative performers, and American has been successful at translating solid results into inflows, it also makes sense to examine whether asset size may now be an impediment.

Bond Fund of America ABNDX
Category: Intermediate-Term Bond
Three-Year Return (% Rank in Category): 5.19% (4)
Five-Year Return (% Rank in Category): 5.71% (4)

This fund certainly has taken on some risk to achieve its fine relative returns, and I can envision some rougher times ahead for it.

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