Wednesday, August 8, 2012

The Real American Funds Problem

My post today will center around some facts that were not pointed out in a recent article I read on entitled A Tale of Two Fund Giants.  The article can be read here:

The article focused on how two very large fund families, the American Funds and Vanguard Funds, have been moving in opposite directions, when it comes to asset inflows and outflows.  The facts are accurate but the article suggests that performance is the reason for the American Funds recent slide in favorability amongst advisors.   Since the American Funds are exclusively sold through advisors then it is fair to assume that financial advisors are at the heart of the problem for the American Funds.


The article suggested that performance was the major contributing factor to the American Funds sudden problems attracting new inflows and preventing outflows.  My thoughts on this are simple……you get what you pay for.  My biggest problem with the American Funds as a one stop place for an investors dollars is the little diversification they offer investors to do so.  They are a mega/large cap institution.  They have been around for so long, that in many cases they are the single largest shareholder of some of the largest capitalized stocks in our economy.  Throughout the 1990’s this became a growing concern for the American Funds.  Their fear was that if one of these stocks ran into problems then it could absolutely destroy one or two of their funds that hold the stock.  As a result, they began to spread these large positions out across most of their funds.  The end result has been very little diversification across their fund base and highly correlated returns.

The article suggests that financial advisors are blaming performance for their decision to direct client assets away from the American Funds.  This is a bunch of bologna and I will explain the real reason in a little bit.  What type of performance did investors and advisors expect to receive last decade?  The decade earned the title the “Lost Decade” because between the years 2000 and 2009 the S&P 500 index lost 9.1% of its value.  The index is primarily a large cap index.  Being that the American Funds are a large cap institution they should have performed poorly in that decade.  Large caps were out of favor.  Here is the performance (not including the very important sales charge) of four flagship American Funds during the “Lost Decade”:

American Funds Washington Mutual A (AWSHX)  +31.89%

American Funds Investment Company of America A (AIVSX)  +28.02%

American Fund Growth Fund of America A (AGTHX)  +26.03%

American Funds Fundamental Investors A (ANCFX)  +42.50%

While the returns were not robust, you can see that these funds actually held up very well in an environment when large caps were out of favor and underperforming other asset classes.  Today we are in an environment where large caps are soaring and carrying the markets higher.  Over the last twelve months for the period ending August 7, 2012 the S&P 500 is up 27.97%.  That is an incredible return that not many people are talking about.  Again, the American Funds are a large cap firm, and you should see a correlation in returns to the large cap S&P 500 index.  Here are the returns of these same four flagship funds over the last twelve months:

American Funds Washington Mutual A (AWSHX)  +26.87%

American Funds Investment Company of America A (AIVSX)  +24.13%

American Fund Growth Fund of America A (AGTHX)  +21.89%

American Funds Fundamental Investors A (ANCFX)  +23.99%

The Real Reason For Outflows

While financial advisors are quick to blame past performance for their reason to instruct clients to sell the American Funds, the pure and simple reason is cold hard cash.  Performance has nothing to do with the departure, and if it did then the advisors should be the ones questioned for putting all of their client’s assets in one asset class (large caps) to begin with.  The fee based advisory platforms at the major firms are the reason why the American Funds have been losing assets.  In the past an advisor would sell the American Funds, collect a nice commission up front on the sales charge, and then have their clients hold the funds forever.  Advisors had incentive to do so because they were collecting an annual fee, called the 12b-1, every year based on the total amount of assets they had with the fund family.  The trailing fee was .25%.  Once the fee based platform became common place at the firms the advisors simply did the math.  Why collect .25% per year when you can move those assets into a fee based platform and earn anywhere from 1% to 2.5% per year of the clients total assets?  It’s not hard to understand but yet was never talked about in the Journal article.

I come from a very small town.  However, that very small town sported one of the biggest American Fund books in the country.  For quite some time the advisor there had the largest amount of American Fund assets per advisor in the country.  He began his career in the 1960’s and you can still walk around town and run into someone that will tell their story of the fortunes he and the American Funds made for that person over the long-term.  By the end of his career the book had become so large, and he was getting up there in years, that he then began to work as part of team of advisors.  The team members were chomping at the bit for him to finally retire.  Since his retirement over three years ago the American Funds book of business has been purged.  Imagine going from making .25% per year on all of those assets to making 1% or more per year.  That is quite a pay increase!

If anything this mass shift out of the American Funds by advisors over the last few years has probably cost their clients a nice return on investment.  They supposedly made this shift based on past performance and ever since the shift, large caps have once again established a leadership position, which means the American Funds will follow.  Anyone ever hear of reverting to the mean?  If advisors had any clue how to build a true tactical allocation portfolio for clients, then they would not have had them buried in just large caps for over a decade.

I thank the author for bringing this shift out of the American Funds to our attention, but I wish he would have dug a little deeper into the real reason why this is taking place.

Thank you and good luck everyone!

Disclosure: I do not own any American Funds and I do not currently own any American Funds in my AFL Models

Jon R. Orcutt, founder of Allocation For Life, is an asset allocation strategist and author of “Master the Markets with Mutual Funds: A Common Sense Guide To Investing Success”; Manager/Creator of the AFL Model Portfolios available for members of Allocation For Life in self-directed accounts at Folio Investing