Capital Group’s Superlatives and Challenges

Capital Group, well known in the United States as the parent of the American Funds open-end lineup, has long been a model asset manager in many respects and was a 2019 nominee for Morningstar’s Exemplary Steward award. It has, however, faced two big challenges over the past decade: one in fixed income, which it has largely met; the other in staying ahead of capacity constraints, where there’s room for progress.

This Fund Spy represents the latest conclusions drawn from Morningstar’s ongoing stewardship evaluation of Capital, which includes two visits with firm leadership in March 2019. It first discusses the superlatives that make Capital stand out, including its periodic firmwide efforts to rethink its organization. It then moves on to Capital’s fixed-income improvements and the need to specify the multimanager system’s limits within equities.

Capital's Competitive Advantages With $1.9 trillion in assets under management, as of June 2019, Capital Group has become a Goliath among active managers through serving investors well, especially with its equity and allocation offerings. Capital's signature multimanager system, first pioneered in 1958, drives its success. The system divides each fund into independently run sleeves and lets managers invest in line with their styles, enhancing diversification and reducing the overall portfolio's volatility. The funds' analyst-led research portfolios help develop the next generation and recruit top talent with the promise of running money from the start. The result is an investment culture marked by lengthy tenures, strong manager fund ownership, and competitive long-term records.

Indeed, skeptics of active management should take note of what Capital’s American Funds equity lineup has accomplished. Exhibit 1 shows that over the past two decades through June 2019, 11 of the firm’s 12 equity funds with a track record that long have beat both their Morningstar Category Index and peer norm, on an absolute and risk-adjusted basis.

Even the one exception, American Funds SMALLCAP World SMCWX, has been competitive. Its 20-year record through June 2019 fell short of the MSCI All-Country World SMID Index by 5 annualized basis points and looked worse from a risk-adjusted standpoint, thanks largely to a disastrous showing in the early 2000s bear market. But its return in the rally preceding that bear market more than doubled the index, and the fund has the superior record since the index’s mid-1994 inception, both absolute and risk-adjusted.

Not Content to Rest on Its Laurels The sustained success of the American Funds equity lineup isn't guaranteed. The shift away from active management and toward passive indexing continues to force out weaker players. This trend shows no signs of abating.

Yet, Capital Group isn’t resting on its laurels. Between late 2017 and April 2018, it examined, as it does every seven to 10 years, what it needs to do to build on its record. Eight working groups of investment and non-investment personnel spent months discussing structure; tools, technology, and data; and professional investor development and diversity. Their efforts led to more than 30 actions first taken in 2018’s second half, including moving 30 investment personnel among its three equity subsidiaries, Capital World Investors, Capital Research Global Investors, and Capital International Investors.

The reorganization helped boost American Funds SMALLCAP World’s Morningstar Analyst Rating to Silver from Bronze. Three of its managers stayed on the fund while switching subsidiaries when the firm in July 2018 added CII as a subsidiary alongside CRGI and CWI. Each division shares the same fundamentals-based, long-term-oriented investment philosophy, but has different investment ideas, so the addition should enhance the fund’s diversification. It now has a new set of CII analysts scouring the globe for promising small- and mid-cap companies.

Flows into Fixed Income as a Marker of Success While the preponderance of Capital Group's assets are still in its equity American Funds, the family's taxable- and municipal-bond strategies have seen $49.6 billion of inflows in the past five years through June 2019, according to Morningstar data. That's versus $27.6 billion in outflows from the firm's U.S. and non-U.S. equity strategies over the same period.

The bond strategy inflows reflect in part the success of Capital’s post-credit-crisis improvements to its fixed-income approach. Since 2013, for example, Portfolio Strategy Group meetings have fostered more fixed-income manager coordination while the family has demanded more focus and accountability from each fund’s principal investment officer. Fixed-income managers still have considerable latitude to invest in line with their expertise, but they must now take account of PSG guidance on matters like duration and curve positioning.

Capital has also made major investments in fixed-income technology and talent. In May 2018, it completed a multiyear transition to Aladdin, a state-of-the-art risk-management system, and has developed other capabilities, such as systems that highlight opportunities in the muni market. Meanwhile, the firm has added six veteran fixed-income managers since 2015, including Pramod Atluri from Fidelity. He was one of the inaugural nominees for the Rising Talent category of the Morningstar Awards for Investing Excellence in 2019, and at the end of the year will take over the principal investment officer role for the flagship American Funds Bond Fund of America ABNDX from the retiring John Smet.

Morningstar has recognized these improvements. As Exhibit 2 shows, eight of the 10 strategies under coverage receive Morningstar Analyst Ratings of Bronze, while the remaining two get Neutral ratings.

Capacity Proactively addressing its own money management limits remains the challenge Capital Group has yet to meet. It isn't that Capital pays no attention to capacity. It pays a lot. A 14-member investment policy group sets individual company ownership limits and liquidity thresholds across subsidiaries, within subsidiaries, and at the fund level. An investment committee within each subsidiary then enforces those guidelines. Each subsidiary can own up to 9.25% of shares outstanding in a single firm. After that, it must petition its committee to own more. There is a hard stop at 12.25% and decisions to let a subsidiary increase ownership toward that stop are based on the stock's liquidity using 100-day moving averages, trading nuances, and the investment thesis. While Capital has yet to hit the 36.75% implied maximum limit in a single firm across all three equity subsidiaries, individual company ownership can be significant. At year-end 2018, its subsidiaries owned a combined 26.05% of the shares outstanding in the then $20.58 billion market-cap company Concho Resources CXO.

The difficulty comes at the fund level. Funds run by one equity subsidiary have a 6.5% ownership limit in shares of outstanding of a single company, which increases to 8% for funds run by two equity subsidiaries, and 9.5% for funds run by all three equity subsidiaries. While that provides sufficient capacity for most of the strategies at present, it begins to meaningfully narrow the investment universe of the largest ones, like the nearly $200 billion American Funds Growth Funds of America. At its June 2019 size, building a 50-basis-point position in a $10.17 billion market-cap company would have put the fund at the limit of its internal 9.5% cap on ownership of shares outstanding in a single firm. That then excluded 48% of the holdings in the Russell 1000 Index from the possibility of a 50-basis-point initial weighting in the fund, and nearly 60% of the holdings in the MSCI All-Country World Ex-U.S. Index, which is relevant here as Growth Fund of America can invest up to 25% of its assets overseas.

To the extent that Capital Growth has identified limits for its investment strategies, it has done so by comparing their size to the aggregate market cap of the primary prospectus benchmark for each. Specifically, “If a particular fund’s or mandate’s assets reach 1.5% of its investment universe, it triggers a close review to be sure we are adequately pursuing superior returns.” [1]

Applying that standard to the S&P 500-benchmarked Growth Fund of America would mean, at June 2019 market valuations, it could become a $366 billion fund before triggering a review. That size would considerably narrow the fund’s investment universe, excluding two thirds of the holdings in the Russell 1000 Index from the possibility of a 50-basis-point initial fund-level weighting, and almost four fifths of the holdings in the MSCI All-Country World Ex-U.S. Index.

Adjusting for historic valuations, Growth Fund of America has been that big before. After $52 billion of inflows over the prior three years ($96 billion by today’s standards), Growth Fund of America’s size between October 2007 and September 2010 was on average 1.55% of the S&P 500’s then aggregate market cap. Capital responded not by closing the strategy to new investors but by raising its cap on non-U.S. stocks in 2010 to its current 25%, from 15% previously.

Around the time Growth Fund of America peaked in size, U.S. mid-cap stocks surged. Between December 2008 and June 2011, the Russell Midcap Index’s nearly 100% cumulative gain doubled the return of the mega-cap Russell Top 200 Index. Growth Fund of its America, for its part, placed in the middle of the pack within large growth in 2009 and in the category’s bottom third in both 2010 and 2011. In contrast to the late 1990s, when Growth Fund of America’s much smaller asset base enabled it to keep more than one third of its assets in mid- and small-cap stocks combined, its mid- and small-cap stake between December 2008 and June 2011 averaged about 9%, versus 21% for the Russell 1000 Growth Index during that period.

The Urgency of Now There is greater urgency now for Capital Group to specify the limits of the multimanager system, especially if the U.S. equity strategies begin seeing substantial inflows again. That's because, since October 2015, Capital has been replicating funds like American Funds New Perspective ANWPX and American Funds Investment Company of America in Europe, Australia, and Asia. Unlike the firm's prior use of similar mandates abroad, these funds aim to match as closely as possible the holdings and investment results of their U.S. namesakes. The potential for U.S. and non-U.S. investors to pour money into the same strategies raises the stakes for capacity monitoring.

Capital, to be sure, has shown some progress since Morningstar’s last stewardship update. Monitoring the liquidity profile of American Funds SMALLCAP World’s portfolio led the firm to decide not to offer it in Europe, Australia, and Asia. Yet, it is still not clear what Capital Group regards as that strategy’s capacity range, not to mention other strategies.

An Opportunity to Set a New Standard Capital Group still has many strengths, including an improved fixed-income lineup. As the nearly 90-year old asset manager advances toward the century mark, it is poised to be better than most. But to be its best will require Capital to set a new industry standard for transparency in monitoring and managing capacity, including outlining the conditions that would lead to proactive closure of a fund to new investors, something the firm has said it would be willing to do.

[1] Capital Group, Strategy Insights December 2016, Asset Growth and Size – Equity, 6.