American Funds is the biggest loser in shift toward passive investments

Jan 22, 2012 @ 12:01 am

By Jason Kephart

More than any other mutual fund company, American Funds is bearing the brunt of investors' latest infatuation with passive investing.

Index mutual funds took in a record $76 billion last year, and exchange-traded funds, which are predominantly passive, scored another $121 billion. Actively managed funds, meanwhile, lost about $9.4 billion, according to Morningstar Inc.

That change in preference has spelled disaster for American Funds, which grew to become the second-largest fund family, with more than $854 billion in assets, on the strength of its active management.

Last year, American Funds had net outflows of $81 billion, up from $18 billion in 2008. For a different perspective on American Funds' problems, consider this: With $33 billion in net outflows, the company's flagship mutual fund — American Funds Growth Fund of America Ticker:(AGTHX) — had more outflows last year than all the funds at any single company.


In total, since the end of 2007, American Funds has shed about 15% of its assets.

The outflows have given advisers reason to be concerned.

Eric Toya, vice president of wealth management at Trovena LLC, said that he is watching the American Funds in his clients' 529 plans to see if the outflows create “hidden” costs, such as tax consequences from forced selling or extra transaction costs.

“The biggest thing we're looking for is managing expenses,” he said.

Of course, it doesn't help that American Funds' performance hasn't been consistent year in and year out. Last year, the company's average mutual fund beat 65% of its peers, up from 43% in 2010.

“Some of our funds have not performed as well as we would like in the short term,” said American Funds spokesman Chuck Freadhoff. “We feel that the way we manage money has produced solid returns over the long term and we're not going to change that.”

The company's underperformance — whether it be long-term or not — caught many advisers by surprise, said Kevin McDevitt, an analyst at Morningstar.

“Advisers may have had unrealistic expectations that American Funds would hold up in any market because of how they did in the early 2000s,” he said. “They didn't do as well in the last bear market, and some of the outflows are a hangover from that.”

At least part of the company's problems also can be attributed to advisory firms' shift toward fee-based business models, from models based on accepting commissions. That shift, which has been occurring in fits and starts over the past 15 to 20 years, has led more advisers to sell no-load funds — rather than the load funds sold by American Funds.

Advisers' intense scrutiny of fees and expenses — no doubt a byproduct of the low-interest-rate environment — has spurred interest in passive investment products, which are cheaper than those that are actively managed.

It certainly hasn't helped the case for active management that 2011 saw two of its brightest stars, Pacific Investment Management Co. LLC's Bill Gross, and Bruce Berkowitz, founder of Fairholme Capital Management LLC, have their worst year.

The $7 billion Fairholme Fund went from being the top performing large-cap-value fund in 2010 to the worst-performing fund in 2011.

The struggles of active managers aren't exactly new. (See: Top actively managed fund firms in 2011.)

In each of the last 10 years, more than half of all active equity managers have beaten their benchmarks only four times, and in none of those years did more than 63% beat their benchmarks.

Long-term performance hasn't been much better. Over the past five years, only 48% of active equity managers have had better total re-turns than their benchmarks, ac-cording to Lipper Inc.

Other giant fund families, such as Fidelity Investments and BlackRock Inc., have been expanding their index fund lineups over the past year. Fidelity added five index funds, bringing its total to 13. The firm's index mutual funds had inflows of $1.6 billion, while its actively managed funds lost about $29 billion.

The Charles Schwab Corp. also is making a big push for index mutual funds. It plans to launch an index-fund-only bundled 401(k) product this quarter.

Don't expect American Funds to go the indexing route, though.

“We don't feel that over the long term, investors will do as well with a passive investment as they will active management, and we have the long-term track records to back that up,” Mr. Freadhoff said.

Client demands aren't falling on deaf ears at American Funds, though.

The firm is readying its first major product launch in more than a decade. Eight funds of American Funds will be launched in May, geared around investment goals, such as growth, income or tax preservation, rather than asset classes. The funds will offer a one-stop shop for manager diversification at American Funds.

Mark Delfino, managing director and chief investment officer at HoyleCohen LLC, is one adviser who has sold his holdings at American Funds in order to buy cheaper alternatives.

He had owned the $75 billion American Funds Capital Income Builder Fund (CAIBX) in a number of model portfolios, but he began to cut his stake in 2009 after being disappointed with the performance.

“With a fund that size, you're not looking for it to be in the top 10%, but you want it to be better than average,” Mr. Delfino said. “We started to ask ourselves, what are we paying for?”

He exited the fund last year and replaced it with a combination of low-cost passive dividend funds and smaller, more focused actively managed funds. The sideways market is putting pressure on margins, and paying lower fees for funds helps relieve some of that pressure, he said.


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