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Capital Group Stays at the Top Through Hard Work

The equity side of American Funds' parent company remains among the best, and it's making strides with its fixed-income business.

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Morningstar recently issued a new Stewardship Grade for American Funds, a subsidiary of Capital Group. 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, for which American Funds receives an A. 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 Advisor Workstation(SM), Morningstar Office(SM), and Morningstar Direct(SM).

Capital Group and its subsidiaries, including American Funds, remain among the industry's strongest stewards of investors' capital. With more than $1.4 trillion in assets under management, over 7,000 employees, and a history that goes back longer than eight decades, Capital Group long ago showed itself to be an enduring franchise. Reaching that apex required continual evolution, including the creation of the firm's multimanager system six decades ago. The development continues today, as the firm finds its footing in a changing fixed-income environment and a market more skeptical of active management. Through it all, keeping focused on investing, generating strong long-term results, and committing to financial advisors has made the company one of the world's largest asset managers, and it earns the firm a Corporate Culture grade of A.

It helps that investors have remained firmly at the helm of this privately held company. Longtime portfolio managers such as Tim Armour, Rob Lovelace, and Darcy Kopcho constitute the majority of the firm's seven-person management committee. Armour, already the committee's chair, became chairman of Capital Group in July 2015 following the unexpected passing of Jim Rothenberg. With the other committee members, he'll continue to set the firm's overall business direction, which mirrors the patient and long-term approach that has long been the hallmark of the firm's investment offerings. There's little chance that Armour's recent appointment will change that cultural tenor.

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. (Financial advisors, through whom the company gathers most of its assets, can also play an important role here.)

The multimanager system also has its advantages when transitioning portfolio managers on and off funds. Easing managers onto 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 have usually already clocked in 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 assemble groups of complementary managers.

In the past, the firm was famously private, eschewing media interviews and providing little insight into the inner workings and portfolio contributions of its individual managers. However, six consecutive years of asset outflows--the firm saw net outflows from its U.S. mutual funds of about $250 billion from 2008 to 2013--prompted efforts to be more forthcoming. In late 2013, Capital Group improved its transparency with new reports for advisors and institutions. Those parties can now see the portfolio characteristics, top holdings, and country and sector exposures for each named portfolio manager, as well as the overall research portfolio. And amid the continually growing flow of assets to index-based strategies, senior management has also been more assertive in spreading its message on the benefits of active management.

Still, other aspects of disclosure surrounding the multimanager system reflect Capital Group's continued insular, private nature. Although the firm satisfies the letter of current regulation, it acknowledges that there are some portfolio managers, generally running less than 5% of a fund's assets, who aren't disclosed in fund documents. The firm says this gives analysts something of a trial period, both to assess their skills and 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. Capital Group isn't the only fund company to exercise these options, but this kind of omission is unusual, and the practice is 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, Capital Group's investors enjoy some of the most stable and long-tenured investment teams around. That level of experience includes not only portfolio managers but 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 Group's career analyst path ensures that 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 Group, 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 it's not unusual for candidates to go through several dozen interviews as the firm tries to assess a candidate's fit for the firm'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. Morningstar assigns medals to all 14 of the firm's non-fund-of-fund equity strategies, including 10 Gold Analyst Ratings. Few other large, diversified asset managers enjoy similar commendation. Of the 12 equity funds with at least a decade of history, all outpace their respective peer group medians, and seven rank in their groups' top quartile.

Such strong results stem from an incentive plan that emphasizes the longer term by using one-, four-, and eight-year returns. In a market that is increasingly sensitive to short-term fluctuations, the firm's longer-term incentive structure allows managers to avoid a myopic view of the market and provides a real competitive advantage. 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.

Working to Better Its Bond Business
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. Though low personnel turnover has benefited investors overall, the resultant insularity may have hindered the fixed-income team as its members appeared somewhat cloistered from a rapidly changing fixed-income market.

To Capital Group's credit, it has been addressing some of its weaker areas during the past few years, including taking the uncharacteristic step of hiring experienced outsiders at various levels and functions to provide much-needed perspective. One such hire was Pasi Hamalainen, formerly a portfolio manager with PIMCO. He was instrumental in helping the firm make major strides to catch up with competitors, particularly in portfolio risk monitoring. Hamalainen unexpectedly passed away in January 2014 at the age of 46, but he left his mark: Capital Group seemed to have recognized the value of an outsider's perspective and hired Mike Gitlin, formerly head of T. Rowe Price's bond business, in 2015 to lead the firm's fixed-income unit. The role is a first for Capital Group, which previously led all of its investment units by committee, and it underscores how much the firm is willing to change. Other hires include those on the risk monitoring side and an experienced high-yield manager, an area in which the firm continues to add analyst resources.

Since 2008 when its bond offerings stumbled during the credit crisis, Capital Group has gradually 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.

The changes further the firm's relatively newfound goal for its fixed-income offerings to act as buffers to choppy equity markets rather than as sources of meaningful growth. It's a reasonable tack that similar large and respected firms, such as Vanguard, also take. The modest goal seems achievable, and the firm's low expenses can particularly help in this aim. Strong performance in August 2015's volatile market was an important victory for funds such as  American Funds Bond Fund of America (ABNDX) and  American Funds Intermediate Bond Fund of America (AIBAX). Watching these flagship funds through a few more market stress points will help solidify confidence in the fixed-income funds' longer-term success.

 

Embracing Change
Capital Group has also made changes to its fund lineup in recent years. In 2012, the firm says it largely acquiesced to advisor demand by launching eight static-allocation funds of funds and seven college target-date funds of funds. More recently, in August 2015, the firm added three funds of funds intended for retirement-income seekers. These new multifund products have been instrumental in reversing the firm's multiple years of net outflows. Including the firm's target-date series, its funds of funds collectively have $54 billion in assets. Historically, the firm tended to create new funds based on research opportunities identified by its investment teams, and then only sporadically. The diversified emerging-markets strategy  American Funds Developing World Growth & Income (DWGAX), which started in February 2014, more closely fits that bill. It's at least reassuring to see that these new offerings are not particularly trendy in nature and that they fit with Capital Group's low-turnover, long-term, and moderate approach.

The firm has stepped up its sales and marketing efforts around the world as well, though here too, the effort has been measured in its focus on education rather than pushing product. In Europe, the sales staff has grown to roughly 40 from five in just the past few years. In 2013, the firm's U.S. external wholesale force jumped to 150 from 115 as those wholesalers shifted to a more consultative approach. The firm also introduced an explicit U.S. sales goal in 2014--a metric that's not unusual at other asset-management firms, though new at Capital Group. A year later, the firm's salesforce met the goal, and it looks to be a regular feature going forward. So far, there's no cause for alarm that it will shift the firm's culture toward a more sales-oriented one; the goal is modest--it aims to roughly match the firm's annual redemption rate, and there are no discernable consequences to not reaching the number.

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 Group'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 manage mutual funds as well as separate-account assignments. For mutual fund investors, it means the addition of a new equity team to the mix, though one that's not an entirely unknown entity. After all, the previously solely institutional group operates under the same incentive system and enjoys the same resources as the retail group.

With the change, Capital Group still has three distinct equity research teams--the legacy retail side already had two equity teams. In 2002, Capital Group almost doubled its equity investment personnel when it split into retail and institutional teams, and that retail team later doubled and split again into two teams. Creating three distinct and largely independent entities has been one of the ways that Capital Group has maneuvered around its size. For instance, since the three groups (Capital International, Capital Research Global Investors, and Capital World Investors) are separate legal entities that report their holdings separately, they avoid triggering certain rules pertaining to large shareholders.

The large size of many of its funds still practically prevents the firm from accessing the smaller-cap areas of the markets. Still, combining the equity teams' disaggregation with the modular nature of the firm's multimanager system, Capital Group's equity teams have delivered strong results even in the face of naysayers (which include Morningstar) calling for the firm to close its larger funds.

There's no doubt that Capital Group 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, the firm remains a shining example of a strong investment culture.

This article is the Corporate Culture portion of the Morningstar Stewardship Grade for funds for this fund family. Visit our corporate website to see Morningstar's Stewardship Grade methodology.

Janet Yang Rohr, CFA does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.