American Funds Adapts to Changing Markets

Morningstar recently issued a new Stewardship Grade for American Funds. The firm's overall grade--which considers corporate culture, fund board quality, fund manager incentives, fees, and regulatory history--is an A. What follows is Morningstar's analysis of the firm's corporate culture. This text, as well as analytical text on the other four Stewardship Grade criteria, is available to subscribers of Morningstar's software for advisors and institutions: Morningstar Principia®, Morningstar Advisor Workstation(SM), Morningstar Office(SM), and Morningstar Direct(SM).

American Funds' cultural strengths begin at the founding of its parent company, Capital Group, in 1931 by investor Jonathan Lovelace. Since then, investors have remained firmly at the helm of this privately held company, and longtime portfolio managers such as Tim Armour, Rob Lovelace, and Jim Rothenberg comprise the majority of the firm's management committee. That group sets the firm's overall business direction, and its guidance mirrors the patient and long-term nature that have long been the hallmarks of the firm's investment offerings.

The firm pioneered the use of multimanager investing in the 1950s, and the system has since become inextricably tied to the firm's identity. The current structure allows sometimes a dozen or more managers, and usually analysts as well, to independently manage slices of a fund's portfolio. This generally results in well-diversified funds that are less volatile than their respective peers, helping investors to stay in them through all sorts of market environments (though financial advisors, through whom the company gathers most of its assets, also play an important role here).

The multimanager system also has its advantages when transitioning portfolio managers (called portfolio counselors by the firm) on and off funds. Easing managers on to small slices of funds means that investors won't experience the jarring change in investment process that sometimes occurs with single-manager funds. In addition, managers usually already have multiple years of live performance history as analysts before they're named to a fund's official roster; that gives the firm's senior leaders plenty of time to observe each manager's investment style, helping those leaders to assemble groups of complementary managers.

In the past, investors had little insight into which managers were contributing to a fund's returns and how. However, six consecutive years of asset outflows plus a secular decline of pension plan assets have helped prompt more responsiveness to investors' and advisors' desire for more information. From 2008 to 2013, the firm saw net outflows from its mutual funds of about $250 billion, representing an average organic loss of almost 5% each year (market appreciation still kept the firm on a positive asset trajectory during that time). So, in late 2013, Capital improved its transparency with semiannual reports for advisors and institutions. Those parties can now see the portfolio characteristics, top holdings, and country and sector exposure for each named portfolio manager, as well as the overall research portfolio. At the end of 2013, for instance, the named managers on  American Funds Growth Fund of America (AGTHX) demonstrated a wide range of viewpoints, each owning anywhere from 23 to 57 holdings, and their weighted median market cap ranged from $38 billion to $98 billion.

Still, other aspects of disclosure surrounding the multimanager system reflect American Funds' insular, private nature. Although American satisfies the letter of current regulation, the firm acknowledges that there are some portfolio managers, generally running less than 5% of a fund's assets, who aren't disclosed in fund documents. American says this gives analysts something of a trial period, both to test their skills and to allow them to test the portfolio-management waters; but even with a small percentage of assets, these undisclosed managers could be responsible for billions of dollars. American isn't the only fund company to exercise these options, but this kind of omission is unusual, and it's deficient in an industry that's among the most transparent in the financial-services realm.

As for transitioning managers off funds, more often than not, those moves involve retirements or movements of portfolio managers between funds--not investment personnel leaving the firm. In fact, American Funds investors enjoy some of the most stable and long-tenured investment teams around. That level of experience includes not only portfolio managers, but it also extends to the firm's analyst roster. In contrast to other firms, where being an analyst often represents a mere stepping stone to a coveted portfolio manager position, Capital's career analyst path ensures that the firm's analysts can be just as well rewarded as a diversified portfolio manager. In many cases, portfolio managers also continue to have analyst duties.

At Capital, it's not unusual for portfolio managers and analysts alike to spend their entire investment careers at the firm, starting as undergraduate- or graduate-level hires and finishing at retirement several decades later. Achieving that level of stability starts at the hiring process, where candidates can go through several dozen interviews as the firm tries to assess the proper fit for Capital's collaborative and intellectually charged environment.

That level of exclusivity, along with an unfailing orientation toward longer-term investing, has worked well for its equity offerings; six out of American's 12 equity funds place in their respective group's top quartile over the past decade through June 2014, and all place in the top half. The firm's incentive plan emphasizes four-and eight-year returns, and in a market increasingly sensitive to short-term fluctuations, the firm's longer-term incentive structure allows managers to avoid a myopic view of the market. That level of patience has fueled the firm's equity fund performance and is entwined with the firm's low personnel turnover and level-headed culture.

The firm's defining features haven't translated as readily to success in its fixed-income offerings. As bond markets have evolved during the past decade to become more interconnected and reliant on macro considerations, the firm's multimanager format and traditional focus on bottom-up, fundamental credit research have held it back. Although low personnel turnover has benefited investors overall, the firm's insular qualities may have hindered the fixed-income team, as its members appeared somewhat cloistered from a rapidly changing fixed-income market.

 

To Capital's credit, the firm has been addressing some of its weaker areas during the past few years. For example, it's been instituting tighter controls in areas that can greatly influence bond fund performance, such as duration or sector positioning. In trying to balance the tension between top-down directives and manager independence, the firm has been using a few new tactics, including formalizing the idea-sharing process, making managers more aware of one another's portfolios, and using analyst and sector portfolios as signaling tools for how diversified managers should consider positioning their investments.

It also took the uncharacteristic step of hiring outsiders for a few senior-level positions. One such hire was Pasi Hamalainen, formerly a portfolio manager with PIMCO. He was instrumental in helping Capital make major strides to catch up with competitors, particularly in portfolio risk monitoring. He was also an unnamed manager on  American Funds Bond Fund of America (ABNDX). Hamalainen unexpectedly died in January 2014 at the age of 46, but he has left his mark: Capital seems to have recognized the value of an outsider's perspective and is in search of a similar fixed-income manager. Capital has also made changes to its fund lineup in recent years. In 2012, for example, the firm largely acquiesced to advisor demand by launching eight static-allocation funds of funds, seven college target-date funds of funds, and three bond-sector funds. Despite the prolific number of newer funds, the firm has historically created funds based on internally determined research opportunities and has done so only sporadically. Capital's newest offering, the diversified emerging-markets strategy American Funds Developing World Growth and Income (DWGAX), was launched in February 2014 and more closely fits that bill. It's reassuring to see that none of these new offerings is particularly trendy in nature. Indeed, the firm also exercised caution in launching its newest bond funds. American seeded the three sector funds--composed of global high-yield, inflation-linked, and corporate offerings--in December 2012 and still has not opened them to outside investors.

The firm has stepped up its sales and marketing as well, though these efforts have been measured, focusing on educating advisors rather than pushing products. American's external wholesale force jumped to 150 from 115 in the past year, as those wholesalers have tried to shift to a more consultative approach. The firm also introduced an explicit sales goal in 2014--a metric that's commonplace at other asset management firms, but one that Morningstar has never encountered with American. A numerical goal in itself shouldn't be cause for alarm (this one is fairly modest, about matching the firm's annual redemption rate). However, it bears monitoring for signs that the firm's culture is shifting more toward sales at the expense of its investment process.

Another potentially far-reaching change prompted by the firm's net outflows involves the 2012 reorganization of its equity team, though even then, there's minimal reason for concern. The diminished role of domestic pension plans has taken its toll on Capital's institutional asset-management business, so in 2012, the firm began the process of taking away the distinctions between retail (mutual fund) and institutional (separate account) investing efforts. Portfolio managers are now organized to run mutual funds as well as separate account assignments. For mutual fund investors, this means the addition of a new equity team to the mix, though one that's not an entirely unknown entity. After all, the previously institutional-only group operates under the same incentive system and enjoys the same resources as the retail group.

There's no doubt that American has seen its share of changes during the past few years. And while the firm's fixed-income evolution remains an open question, there's reason for optimism. Overall, though, the firm remains a shining example of a strong investment culture.

This article is the Corporate Culture portion of the Morningstar Stewardship Grade for American Funds. Click here to see Morningstar's Stewardship Grade methodology.