Was It a Lost Decade for American Funds?

At Morningstar, we take a long-term approach to investing. When we judge mutual fund performance, for example, we don't worry too much about how funds have done over one or even three years. We're much more concerned with five-year and especially, when available, 10-year performance records. Economic cycles typically take longer than five years, so we like to judge funds on the basis of a full run of ups and downs.

I recently took a look at how American's stock and balanced funds have performed for the past decade, which is already being notoriously dubbed the "lost decade" for stocks by many observers. American itself currently has an informative page on its Web site questioning the current "lost decade" mantra and showing relatively impressive annualized returns for its 15 equity and balanced funds that have 10-year records. Here, we'll go a little deeper into the performance numbers and the drivers behind them.

Was it Really a Lost Decade?
First, the decade is being written off by stock investors because the main domestic benchmark, the S&P 500 Index, lost 9% cumulatively from Jan. 1, 2000, through Dec. 31, 2009. It's important to note, though, that this is mostly a large-cap index and that mid-cap and small-cap stocks did considerably better.

For example, the Russell Mid-Cap Index returned 63% cumulatively for the decade, while the small-cap Russell 2000 Index returned 41%. Moreover, foreign indexes outpaced their domestic counterparts. The MSCI EAFE Index gained 12% cumulatively for the decade, but the MSCI Emerging Markets Index returned a whopping 154%.

This shows the benefits of diversification. While painfully absent in the plunge of 2008 and early 2009, when nearly all stocks and bonds collapsed, diversification has helped considerably over the longer haul. Even forgetting about diversification into bonds, there's little doubt that going smaller and going abroad simply within the realm of equities helped cushion the blow that large-cap domestic stocks inflicted on investors.

So How Did They Do?
American's stock and balanced funds did extraordinarily well by any measure. All of them with 10-year records produced positive cumulative and average annual returns for the decade. (Only American Funds International Growth and Income (IGAAX) doesn't have a 10-year record.) All of them also finished in the top-half of their respective Morningstar peer groups. Additionally, 80% of them finished in the top-third of their peer groups, while 73% of them finished in the top quartile of their peer groups.

Not surprisingly,  American Funds New World  (NEWFX), the firm's entrant in the emerging markets category, posted the best performance, with a 122% cumulative return. We're not too concerned that it trailed the MSCI EAFE Emerging Markets Index's 154% return, given that the fund gains its emerging markets exposure through firms domiciled in developed markets. We think American looks at emerging markets investing the correct way--by understanding where a business makes its sales and pays it expenses rather than the location of its headquarters. This approach will typically cause it to lag when emerging markets indexes are roaring because the fund owns fewer of the index's most-speculative stocks.

Emerging markets exposure obviously helped during the decade, and so did bond exposure. Therefore, it's not surprising to see  American Funds Capital Income Builder (CAIBX) clock in with a 102% return for the decade. This fund usually keeps a 60/40 stock/bond portfolio and views the world as its oyster. It's a great one-fund solution for an investor's allocation, provided the split between stocks and bonds is appropriate. This fund has been the subject of controversy on Morningstar's message boards lately, as we indicated last month, but we think concerns about it are overblown. This should continue to be a fine world allocation choice for years to come.

Similarly,  American Funds Income Fund of America (AMECX) and  American Funds American Balanced (ABALX) posted 79% and 74% cumulative returns, respectively, for the decade. Despite a rough 2008 for nearly all bonds, save U.S. Treasuries, holding bonds helped for much of the decade. Indeed the BarCap US Aggregate Bond Index gained 85% for the decade cumulatively, outpacing both of these funds.

Among American's two global stock funds,  American Funds Capital World Growth & Income (CWGIX) posted a 100% return, outpacing  New Perspective's (ANWPX) 48% return. Both funds handily outpaced the 5% return of the MSCI EAFE AC World Index, but Capital World Growth & Income's conservative posture helped it hold up better during the technology meltdown in the early part of the decade.  American Funds EuroPacific Growth  (AEPGX), American's more aggressive international fund, posted a 44% return for the decade, outpacing the MSCI EAFE's 12.4% return. The performance of these three funds shows that simply going overseas didn't help by itself. Conservative stock selection was the winning ticket for Capital World Growth & Income, whose domestic exposure didn't prevent it from overtaking its siblings.

 American Funds SmallCap World  (SMCWX), American's only small-cap fund, was perhaps the only stinker in the lot. The fund posted a 25% cumulative return for the decade, while the S&P Global <3 Billion Index roared with a 101% return. Additionally, the Morningstar Foreign Small/Mid Growth and Foreign Small/Mid Indexes posted 43% and 67% cumulative returns.

This is a tough fund to judge, because it lands in the world stock category, but its small-cap holdings make comparisons to small-cap international funds and indexes fair. We've long considered this fund our least favorite in American's lineup, so we're not surprised by its underperformance. It's difficult to attribute the causes behind its sluggishness, though it may be getting difficult for its 10 counselors to move its $17 billion asset base around as they stick only to smaller companies.

If American has one foreign stinker, it doesn't have a weak link on the domestic side. All its domestic equity funds outpaced the S&P 500 Index for the decade.  American Funds New Economy (ANEFX) turned in the worst performance with a 3.3% cumulative loss, though that was good enough to surpass the index's 9% decline.  Growth Fund of America (AGTHX) was the next worst with a 26% gain. It makes sense that American's growth funds would fare poorly, given the technology bubble's bursting at the start of the decade.  American Funds AMCAP  (AMCPX) did a bit better with a 28% return, though that fund typically owns more mid-cap stocks than its siblings.

 American Mutual  (AMRMX) was the best among the domestic funds, with a 54% cumulative return, but it's worth noting that this fund has held up to 20% of its assets in cash and bonds.  American Funds Washington Mutual Investors  (AWSHX) and  Investment Company of America  (AIVSX), which are considered the family's flagships and are more pure stock funds, returned 32% and 28%, respectively.

It was disappointing that many of American's funds held financial stocks late in the decade. The family is noted for its emphasis on dividends, which now-bankrupt financials tended to pay, but the firm's counselors could have been more careful assessing the safety of the dividends and the quality of the firms. Still, they weren't the only talented managers we cover at Morningstar who struggled to correctly analyze financials. What's more, American's domestic funds put up more than respectable relative returns in aggregate for the decade.

A Peek Ahead
Stock investors have now been on a wild two-year ride, experiencing breathtaking declines and heart-pounding surges. We don't think, however, that individual or professional investors are particularly good at timing markets, and those who've managed to stay the course have ended this tumultuous period in decent shape. We think investors should use the experience as a lesson that timing the markets is impossible. Because there's so much uncertainty regarding short-term market movements, investors need to establish asset allocations that can withstand the tumult.

Once an investor settles on a reasonable allocation, we'd consider giving a bit more attention to American's growth funds, Growth Fund of America and AMCAP. Growth stocks have generally done worse than their value brethren for the decade, despite the recent financial crisis, and we'd look to them to outperform. This doesn't mean neglecting value funds such as Washington Mutual altogether; we're only talking about gentle overweights to American's growth offerings.

We also think American's foreign funds will continue to shine. The firm has more than a half century experience in international investing, and that experience shows in the funds' returns. Indeed we've named the counselors of EuroPacific Growth Morningstar Managers of the Year for 2009. The developing world will likely continue to experience economic growth, and we think American's foreign funds have demonstrated an ability to participate in that growth prudently.

Finally, we think Capital Income Builder can continue to serve as a fine one-fund solution for investors seeking a roughly even balance between stocks and bonds for their longer-term assets. Besides providing a moderate asset allocation, this fund gives investors access to American's foreign research efforts. It's a little more aggressive than American Funds American Balanced and Income Fund of America because it holds foreign stocks, but we think it will continue to be a winner.

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