Navigating the Markets' Minefields with American Funds

Upheaval in the financial sector, along with generally bad economic news, has rocked stock and bond markets all over the globe, leading to huge losses. First, a quick look at how we got here: Following the 2007 implosion of subprime mortgages and the decline of the housing market, the broader economy has slowed and credit markets have tightened dramatically (though they have lately opened up a bit). As the market for securitized mortgages dried up, large financial firms that held them--many have also used credit default swaps and other derivatives to take on more leverage and boost profits in good times--found themselves in once-unthinkably dire straits.

As a result, the landscape of the financial sector in the United States has been dramatically altered.  American International Group (AIG), Bear Stearns,  Fannie Mae (FNM),  Freddie Mac (FRE), Lehman Brothers,  Merrill Lynch ,  Wachovia , and Washington Mutual have all either gone under, been acquired at depressed prices, or been taken over completely or in part by the U.S. government. What's more, the remaining large investment banks,  Goldman Sachs (GS) and  Morgan Stanley (MS), are becoming traditional, deposit-based banks instead of continuing as investment banks. The Federal Reserve's plan to buy troubled, marked-down mortgages from lenders in an attempt to revive the credit markets was approved by the U.S. government in early October, yet markets have become even more volatile.

In this article, I'm going to more closely examine which of American's funds were hurt the most by the blowups in financials and by which names, as well as how vulnerable your funds might be to any more turbulence from that troubled area in the near future. While financials' turmoil had less effect on the broader market in October, it's instructive to look at American's performance in that sector, given the substantial permanent loss of capital that occurred there. I'm also going to look at redemptions (which have grown by leaps and bounds across the fund industry as markets have declined) at American's funds and their ability to handle them.

Which Funds Suffered Most?
Broadly speaking, American's longstanding wariness of firms with dicey balance sheets has served shareholders well in this market. It would be a stretch to say that the firm's investment professionals anticipated the extent of the damage done thus far in financials, but when I visited their offices in late 2007, the managers and analysts were generally concerned about potential revelations to come regarding banks' exposure to lower-quality mortgages. Thus, even though the stock prices of the individual firms that eventually blew up had already declined significantly by mid-2008, American's funds owned only small positions in them at that time. Although the funds' holdings as of the end of September are available, the events of that month make it difficult to see exactly what American did before those firms imploded. But based on how the funds have performed, their holdings at the end of June, and my recent conversations with American's managers, damage was limited. Some managers found financials' valuations compelling enough to own them, but worries about their balance sheets generally kept them from loading up on individual names. Indeed, only one fund,  American Funds Amcap (AMCPX), invested more than 1% of its assets in a company that has since gone bankrupt or been acquired at a rock-bottom price; AIG represented 1.7% of the fund's assets at the end of June. That fund didn't buy or sell any shares of the stock during the third quarter.

All told, American's financials analysts deserve a lot of credit. True, the funds haven't had a lot of exposure to the two clear-cut winners among the behemoths in the sector so far this year,  Wells Fargo (WFC) and  J.P. Morgan & Chase (JPM).  American Funds Washington Mutual Investors (AWSHX) held 1.3% positions in both at the end of June, but only a few other funds held at least one of those two stocks, and their positions were far smaller. But shareholders have benefited from the firm's defensive stance in financials. American's 12 domestic- and world-stock funds have all suffered double-digit losses in 2008--a painful experience for investors but understandable in a year in which every Morningstar equity fund category (including sector funds) has lost at least 23% for the year to date through Oct. 31. And the funds have thus far held up relatively well, at least: Nine of the 12 funds have outperformed their typical category rivals this year.

Are Outflows Hampering the Funds?
In this tense environment, some investors have panicked. In September, mutual funds saw the biggest outflows ever in a single month--a net $478 billion, according to Morningstar's data. As the biggest fund shop around, American has certainly experienced its share of redemptions; investors pulled $8.5 billion out of the funds that month. That's a slightly higher percentage of overall redemptions--17%-- than the percentage of mutual fund assets that American runs (13%), which is understandable given the equity-heavy nature of American's fund assets. And while we don't yet have flow data for October, redemptions almost certainly rose, as stocks performed far worse on average.

Outflows can weigh on funds' returns in several ways. They can force managers to sell stocks into a declining market, thus potentially driving those stocks' prices down further. Such activity can also increase trading costs. There are opportunity costs involved as well if the manager is forced to sell particular stocks that he or she would rather buy more of as their prices drop. However, I think American's funds are especially well-equipped to handle outflows with a minimum of disruption. First, many of the equity funds have historically held bigger cash stakes than their rivals, which could be used to meet redemptions before the managers have to sell any stocks. For example,  American Funds Growth Fund of America (AGTHX) recently held 11% of its assets in cash, compared with 2% for the typical large-growth fund. All told, 10 of American's 12 equity funds recently held at least 9% of their assets in cash. Second, the funds' generally massive asset bases, which I have worried could weigh on the funds' future long-term returns, are ironically a bit of an advantage here. Those cash positions are quite large, on an absolute basis: Growth Fund of America weighed in at $157 billion at the end of September, which means its cash stake amounted to $18 billion. That's far bigger than the rest of the funds' stakes, but each one had at least $900 million in cash at the end of September (the median figure was $3 billion). Finally, each fund, with the exception of  American Funds New World (NEWFX) and  American Funds Smallcap World (SMCWX), focuses heavily on large-cap firms, which tend to be heavily traded--so unloading their shares typically isn't difficult.

To sum up, American's equity funds have suffered painful absolute losses, but, on a relative basis, they've weathered this storm fairly well so far. Furthermore, investors have plenty of reason to be confident that American's investment professionals will navigate any rough seas ahead better than most. The firm's historically risk-averse investing style, as well as the expertise and sheer depth of its research staff, bode well for its prospects. Also, I don't think redemptions have weighed much on the funds' returns, and I don't expect them to going forward, barring a truly massive panic. Although markets the world over could be in for substantially more pain, American Funds investors should stay the course. It's difficult to choose the right times to buy and sell stocks, and getting out of the equity market after an already-substantial decline has historically been a bad idea. 

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