American Funds Keeps Rolling

Morningstar

Another Fine Year
I have something of an obsession about American Funds--to the point where a Capital Research employee sent a LinkedIn invitation that identified me as a colleague at the firm. (Perhaps he ticked the wrong box by accident. At least, so I hope.)

The company intrigues me because, as one of the world's largest active stock managers, it very visibly accomplishes what index-fund proponents claim cannot be done: outperform year after year, decade after decade.* Yet despite the results, nothing seems to change. Professors and pundits continue to decry the folly of active portfolio management, and American Funds continues to suffer the recent fate of many active stock-fund managers: net redemptions.

*This column applies only to the company's stock funds. American Funds has no special touch with its bond funds.

Last year was no exception to the typical American Funds pattern: strong results, continued outflows.

In the past, when evaluating American Funds, I've measured how its funds fare against the category averages. That approach makes sense if the subject is the predictability of performance; that is, if addressing the argument that active-manager performance is a completely random, nonpredictable event. By now, we can--or at least should--consider that debate to be settled. The entire stable of American Funds U.S. stock funds reliably beats its peers.

So this time, I compared the funds against indexes, to address a different question: Has it been better to own these actively managed funds than their passive alternatives? As is customary for performance comparisons, the fund calculations assume that the investor held the fund entering and exiting the time period, with the result being that they include all ongoing costs but not the initial sales charge.

The indexes, from Russell and MSCI, are the benchmarks that Morningstar assigns to each fund's investment category. Also following custom, the indexes used for the benchmark comparisons are costless. (A dubious assumption, but it has little effect on the outcome.)

I looked at two time periods, a checkup on calendar-year 2013 and an evaluation over the more meaningful period of the trailing 10 years through Dec. 31, 2013. The checkup is on total return alone, as it is difficult to use risk/return measures over a mere 12 months. The longer-term evaluation uses risk-adjusted return, which is the most appropriate method for gauging success (or failure). I could have selected Morningstar's Risk-Adjusted Return measure, which gives very similar results, but chose instead the Sharpe ratio, which is the institutional standard.

The results are shown as performance differential--the fund's total, minus that of the index. A positive number means that the fund beat the index, and a negative means the opposite. The 2013 figure is in percentage points of total return, while the 10-year number represents the advantage (or disadvantage) that the fund held in Sharpe ratio.

For the year, eight of the company's 12 stock funds beat their category benchmarks. Only American Funds American Mutual (AMRMX) trailed by a significant amount, but its performance can scarcely be called disappointing, as it was a booming bull market and the fund is cautiously run, carrying less than 80% the risk of the S&P 500 (or the benchmark used in this column, Russell 1000 Value). Five other funds finished roughly in line with the benchmarks, leading or lagging by 2 percentage points or less. The remaining six thumped their yardsticks by an average of nearly 7 points.

The 10-year results are positive in 11 cases out of 12. American Funds Investment Company of America's (AIVSX) Sharpe ratio is fractionally behind that of the Russell 1000. Otherwise, each of American Funds' stock funds has outperformed its comparison index on a risk/return basis. The test would look better yet for American Funds if the time period were extended to 15 years, as American Funds enjoyed among its best relative performance ever during the 2000-02 technology bear market.

The firm's reward? It was the second-most-redeemed mutual fund company, placing ahead of only embattled PIMCO. That said, redemptions were substantially lower than in the past several years, and, given the company’s large asset base, they were less dramatic when measured as a percentage of assets than when measured in raw dollars.

American Funds must shoulder partial blame for its sales problems. The company permitted expectations to climb dangerously high following its successful 2000-02 period, leading to disappointment and recriminations when it failed to perform a similar miracle during the 2008 market crash. (The same occurred with hedge funds, as unlike the 2000-02 bear market, which could have been--and was--largely avoided by those who were careful about paying high stock-price multiples, the 2008 market had few refuges.)

However, the company has also suffered for the sins of others. Most active managers have not beaten indexes on a net basis, either on total returns alone or risk-adjusted. This has led to the popular belief that such a feat cannot be produced. It can be. The argument for American Funds' stock funds rather than a passive fund in a taxable account is not strong, particularly with the company's U.S. stock funds. In a tax-sheltered account, though, the benefits have been steady and clear.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

John Rekenthaler does not own shares in any of the securities mentioned above.

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