The Two Sides of American Funds

Investors often look at American Funds as a shop that has not only generated fine long-term performance, but also as one that hasn't taken a lot of risk in the process. I generally agree with this perception. However, it's not completely true, and I think it's a good time to take a closer look at the funds' risk profile--there has been significant carnage in the equity and bond markets since the subprime mortgage meltdown triggered a credit crunch in early 2007. Dicier fare has gotten its comeuppance after enjoying a big four-year surge in the post-bear-market rally.

American's equity funds, which account for more than 90% of American's mutual fund assets, are broadly diversified and tend to avoid extremes. None of them loads up on richly priced fast growers or dirt-cheap, troubled companies. For example, the portfolios of each of American's large-growth funds ( Amcap (AMCPX),  Growth Fund of America (AGTHX), and  New Economy (ANEFX)) sport below-average valuations, on average, relative to their typical category rival. As a result, only one fund ( Smallcap World (SMCWX)) has an above-average Morningstar risk rating over the 10 years ended March 31, 2008--and that's only because the fund is in a broad category where most funds focus on steadier blue-chip fare.

Watch Out for Credit Risk
However, American's bond funds are generally a bolder bunch. Some of its taxable bond funds, such as  Bond Fund of America (ABNDX), tend to own bigger stakes in corporate bonds--an attempt to capitalize on the firm's expertise in analyzing individual companies--and thus often take on more credit risk than their category rivals. As for its municipal-bond funds, both  American Tax-Exempt Bond (AFTEX) (its national muni-bond offering) and its single-state siblings dip further down the credit-quality scale, too. The principle is much the same as for the shop's taxable bond funds: American believes it has enough talented investment professionals (more than most shops) to ferret out the most attractive names in dicier areas of the bond market. (It's worth noting that American's bond funds don't take big bets on the direction of interest rates, however.) Thus, the funds have tended to be a bit more volatile than their category rivals over the very long haul. True, there are shorter periods where that isn't the case, but the funds often get hit harder when lower-rated debt hits the skids. One important exception is  High-Income Municipal Bond (AMHIX), which tends to own fewer low-quality bonds than its typical high-yield muni competitor and thus provides a smoother ride.

Weathering The Storm--Or Not?
The differing risk profiles of American's equity- and bond-fund lineups are amply demonstrated by their relative returns during the market's recent upheaval. For the year to date through April 15, 2008, 10 of American's 15 equity funds (excluding its target-date funds, where relative returns are quite dependent on asset allocation) land in the top half of their categories. The laggards include the aforementioned Smallcap World and  Income Fund of America  (AMECX), a moderate-allocation fund that owns far more high-yield bonds than most peers. And over the past 12 months through April 15 (which roughly coincides with subprime's implosion), nine of the 15 equity funds beat their typical rival.

As expected, the bond funds have fared worse--much worse, in fact. Higher-quality bonds have performed far better than their lower-rated counterparts, as the Federal Reserve Board has slashed interest rates in an attempt to stimulate the economy. While lower-rated muni bonds have rallied lately, it has generally been a tough environment for them in 2008. Against this backdrop, just two of American's 12 bond funds have outpaced their typical category rivals for the year to date through April 15--and those two, High-Income Municipal and  Short-Term Bond Fund of America (ASBAX), are just barely ahead. Bond Fund of America, which recently owned 50% more corporate bonds than the intermediate-bond norm, lags 80% of its rivals over that stretch. The story was much the same over the past 12 months: Three of the 12 funds land in the top half of their categories.

I don't think investors should worry much about short-term performance fluctuations--holding on to good funds for the long haul is a fine recipe for investing success. And I think highly of many of American's bond funds; their rewards, on average, should compensate investors for the risks they take. But at the same time, investors attracted to American Funds because of its reputation as a steady-Eddie shop should look particularly closely at any bond funds they're considering. The ride can be bumpy. 

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