Can American Funds Sustain Its Outperformance? - Advisor ...

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Jun 30, 2015 ... from Vanguard and Dimensional Fund Advisors (DFA)? If so, should investors expect its ... average return of those funds in my comparison.
Can American Funds Sustain Its Outperformance? June 30, 2015 by Larry Swedroe Among actively managed funds, American Funds has a reputation for providing investor-friendly, lowcost products with sustained records of outperformance. But has it outperformed comparable funds from Vanguard and Dimensional Fund Advisors (DFA)? If so, should investors expect its funds to maintain their edge? I’ll answer those questions. American Funds is the third largest mutual fund family (following Vanguard and Fidelity) in the United States. According to Morningstar, as of May 31, 2015, American Funds had nearly $1.3 trillion in assets under management across its lineup of mutual fund offerings. The firm is an extremely popular choice among active investors and for some very good reasons. The fees it charges are investor friendly, certainly so for an active manager. American Funds doesn’t rely on “star managers” who can pick up and leave, taking their investment approach with them. Rather, the firm relies on a team of managers. It avoids the style drift that causes investors to lose control over the risk of their portfolios. And finally, the firm has become one of the market’s largest mutual fund companies because its track record is good. The firm’s website states: “We base our decisions on a long-term perspective, which we believe aligns our goals with the interest of our clients. Our portfolio managers average 27 years of investment experience, including 22 years at our company, reflecting a career commitment to our long-term approach.” American Funds describes its investment philosophy as “based on doing what…is right for clients.” It claims to “reward long-term results” through investment professional compensation that’s “heavily influenced by results over four- and eight-year periods” and to “invest alongside” its clients. Collectively, the firm notes, its “associates are significant investors in the company’s investment offerings.” Recognizing the long-term success achieved by the Capital Group (the firm that manages the American Funds family of mutual funds), Charles Ellis wrote about them in his 2004 book, Capital: The Story of Long-Term Investment Excellence.

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Active versus passive As is my practice, and given the firm’s assertions about its long-term investment approach, I’ll compare the performance of American Funds’ actively managed equity funds to similar offerings from two prominent providers of passively managed funds, DFA and Vanguard. (Full disclosure: My firm, Buckingham, recommends DFA funds in constructing client portfolios.) To keep the list to a manageable number of funds and to make sure I look at long-term results through full economic cycles, I will analyze the 15-year period that ended June 12, 2015. Also, I’ll use the lowest cost shares available when more than one class of fund is available for the full period. Furthermore, in cases where American Funds has more than one fund in an asset class, I’ll use the average return of those funds in my comparison. The table below shows the performance of seven funds offered by American Funds in five asset classes.

15 Years Ending June 12, 2015

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Symbol

Annualized Return (%)

Expense Ratio (%)

Fundamental Investors

RFNFX

6.8

0.35

Investment Company of America

RICFX

6.1

0.35

6.5

0.35

Fund U.S. Large Blend

American Funds Average DFA U.S. Large Company

DFUSX

4.5

0.08

Vanguard Institutional Index

VINIX

4.5

0.04

AMCAP

RAFFX

6.9

0.41

Growth Fund of America

RGAFX

5.7

0.38

New Economy

RNGFX

5.3

0.52

6.0

0.44

VIGIX

3.7

0.08

American Mutual

RMFFX

7.6

0.36

Washington Mutual

RWMFX

6.8

0.35

7.2

0.36

  U.S. Large Growth

American Funds Average Vanguard Growth Index   U.S. Large Value

American Funds Average DFA U.S. Large Cap Value

DFUVX

8.9

0.13

Vanguard Value Index

VIVIX

5.8

0.08

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  Foreign Large Growth Europacific Growth

RERFX

5.3

0.54

Vanguard International Growth Admiral

VWILX

4.4

0.34

New World

RNWFX

8.1

0.69

DFA Emerging Markets

DFEMX

8.2

0.56

Vanguard Emerging Markets

VEIEX

8.1

0.33

  Emerging Markets

Before reviewing our results, it’s important to note that the lower-cost R5 share class offered by American Funds is only available to investors in retirement plans. Even though we’re also looking at the lowest-cost version of funds from Vanguard and DFA, their fees don’t increase as drastically across share classes as is the case with American Funds. Moreover, American Funds has a variety of other share classes that it claims allows it “to compensate your financial professional for helping you decide which funds are right.” While the gap between the expense ratios of the lowest-cost and highest-cost funds in share classes from DFA and Vanguard can typically be measured by counting basis points on the fingers of your two hands, the same gap between the American Funds share classes can be more than 1.2 percentage points. And some of the share classes come with sales charges, deferred sales charges or hefty 12b-1 fees (up to 1%). With this very important caveat in mind, the following is a summary of the data in the above table: Of the three asset classes for which there are comparable DFA funds, offerings from American Funds provided a higher return in one of them. Of the five asset classes for which there are comparable Vanguard funds, offerings from American Funds provided higher returns in four of them, and there was a tie in the fifth. An American Funds portfolio equal-weighted in the three asset classes for which there are comparable DFA funds returned 7.3% a year. The portfolio’s average expense ratio was 0.47%. A DFA portfolio, equal-weighted in those same three asset classes, returned 7.2% a year, underperforming its counterpart American Funds portfolio by 0.1 percentage point a year. The portfolio’s average expense ratio was 0.26%.

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An American Funds portfolio equal-weighted in the five asset classes for which there are comparable Vanguard funds returned 6.6% a year. The portfolio’s average expense ratio was 0.48%. A Vanguard portfolio, equal-weighted in those same five asset classes, returned 5.3% a year, underperforming its American Funds counterpart by 1.3 percentage points. The portfolio’s average expense ratio was 0.17%.

Factor analysis We’ll now take another look at American Funds’ performance using the analytical tools and data available at Portfolio Visualizer. The table below shows the results of a three-factor (beta, size and value), four-factor (adding momentum) and six-factor (adding quality and low beta) analysis of the firm’s domestic funds. Factor analysis provides important insights, showing the sources of returns for each fund. For example, Morningstar classifies each fund based on the fund’s holdings in each of its nine style boxes. Thus, during periods when value outperforms growth, growth or blend funds could appear to be generating alpha relative to a (pure) index fund in the same style box while actually generating negative alpha based on its holdings (which include value stocks). Data in the table below covers the period from June 2002 through February 2015. The t-stats are in parentheses.

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ThreeFactor Annual Alpha (%)

FourFactor Annual Alpha (%)

SixFactor Annual Alpha (%)

Fund

Symbol

Fundamental Investors R5

RFNFX

1.0 (1.1)

0.9 (1.0)

0.8 (0.9)

Investment Company of America

RICFX

0.4 (0.6)

0.5 (0.7)

0.1 (0.1)

AMCAP

RAFFX

0.4 (0.4)

0.6 (0.8)

0.8 (0.9)

Growth Fund of America

RGAFX

0.6 (0.8)

0.5 (0.6)

1.5 (1.9)

New Economy

RNGFX

0.7 (0.5)

0.9 (0.8)

2.7 (2.2)

American Mutual

RMFFX

0.9 (1.3)

1.0 (1.4)

0.0 (0.0)

Washington Mutual

RWMFX

0.3 (0.3)

0.5 (0.6)

-0.2 (-0.3)

0.6

0.7

0.8

Average

When we look at the three-factor analysis, we find that all seven of the American Funds offerings generated annual alphas. However, none of those alphas were statistically significant at the 5% level. The average annual alpha was 0.6%. When we examine results from the four-factor analysis, we also find that all seven of the American Funds offerings generated alpha. Again, none of that alpha was statistically significant at the 5% level. The annual alpha was 0.7%. When we include all six factors, we find that five generated annual alphas, one of which was statistically significant at the 5% level. The average annual alpha was 0.8%. At this point, I normally include a caveat warning readers that the returns data I have presented is all pre-tax, and the higher turnover of actively managed funds generally creates a significantly higher

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burden when it comes to taxes. However, using Morningstar data, we discover that the average turnover of these seven American Funds offerings was an index-like 25%. While that remains higher than the 6% average turnover rate of the five Vanguard funds we examined, it’s still pretty low. The average turnover rate of the three funds from DFA that we evaluated was about 8%.

An enviable record The American Funds family of mutual funds certainly has produced an enviable record, whether you’re comparing performance to actively managed or passively managed funds. They outperformed similar Vanguard funds by 1.3 percentage points a year and basically matched the performance of comparable DFA funds (underperforming in two of the three asset classes, but outperforming by 0.1% from a portfolio perspective). There’s a lot about the firm to admire. It keeps expense and turnover ratios relatively low. And, like I mentioned previously, it doesn’t rely on star managers that can leave the firm. What’s more, its managers make significant investments in the funds they run. In addition, factor analysis demonstrates that they tend to avoid the “style drift” which can cause investors in actively managed funds to lose control over their asset allocations and, as a result, the risk of their portfolio. If one had to choose an actively managed fund family, this would be a good choice. A problem for American Funds, and an issue for their investors, is that the hurdles to achieving alpha are growing. One large hurdle the firm faces is a direct result of its own success. They now have almost $1.3 trillion in assets under management, up from less than $1 trillion only four years ago. A growing asset base creates an ever-higher hurdle for active managers because either the cost of trading can increase (market impact costs rise) or they are forced to diversify more (and become closet indexers). Academic research continues to convert what once was alpha into beta, the pool of victims that can be exploited has collapsed, competition has gotten much tougher and the supply of capital chasing alpha has exploded. Those four hurdles are the focus of my latest book, “The Incredible Shrinking Alpha,” which I co-authored with Andrew Berkin, the director of research at Bridgeway Capital Management. With that being said, to determine if there has been any deterioration in American Funds’ ability to outperform, we can look back at the firm’s performance data over the last five years and then compare it to the performance data for the full 15 years.

Five Years Ending June 12, 2015

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Symbol

Annualized Return (%)

Fundamental Investors

RFNFX

15.4

Investment Company of America

RICFX

15.2

Fund U.S. Large Blend

American Funds Average

15.3

DFA U.S. Large Company

DFUSX

16.2

Vanguard Institutional Index

VINIX

16.3

AMCAP

RAFFX

17.3

Growth Fund of America

RGAFX

16.0

New Economy

RNGFX

18.3

  U.S. Large Growth

American Funds Average Vanguard Growth Index

17.2 VIGIX

17.5

American Mutual

RMFFX

14.5

Washington Mutual

RWMFX

16.0

  U.S. Large Value

American Funds Average

15.3

DFA U.S. Large Cap Value

DFUVX

17.1

Vanguard Value Index

VIVIX

15.4

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  Foreign Large Growth Europacific Growth

RERFX

9.9

Vanguard International Growth Admiral

VWILX

10.6

New World

RNWFX

6.9

DFA Emerging Markets

DFEMX

3.8

Vanguard Emerging Markets

VEIEX

3.8

  Emerging Markets

The following is a summary of the data in the table above compared to the results of the full 15-year period: The results for DFA funds and the American Funds were identical. Comparable DFA funds outperformed in two of the three asset classes, but the American Funds portfolio outperformed by 0.1 percentage point. Relative to the Vanguard funds, the American Funds’ results were quite different. For the 15-year period, comparable Vanguard funds didn’t outperform in any of the five asset classes, although there was one tie. But over the last five years, offerings from American Funds underperformed in four. However, the American Funds portfolio still outperformed the Vanguard portfolio, though by a much smaller amount (0.2% for the five-year period versus 1.3% for the 15-year period). For taxable investors, even though the turnover of the American Funds offerings we’ve used in our analysis is low for an active manager, it was still about 20% higher in this period than for the comparable funds from DFA and Vanguard. Given the firm’s slight advantage in pre-tax outperformance (0.1 percentage points versus DFA and 0.2 percentage points versus Vanguard), that higher turnover easily could have resulted in lower after-tax returns. The bottom line is that there was the slimmest margin of outperformance versus the DFA funds (while underperforming in two of the three asset classes) in both periods, and the outperformance gap relative to the Vanguard funds shrunk from 1.3 percentage points to a bare 0.2 percentage points (while underperforming in four of the five asset classes). Consistent with both the historical evidence on the ability of active managers to maintain outperformance and the evidence that the hurdles to generating alpha are getting higher and higher for the overall industry, the performance advantage maintained by American Funds has shrunk, and the recent slim advantage could even turn negative for investors in share classes with higher expenses. It Page 9, ©2017 Advisor Perspectives, Inc. All rights reserved.

remains to be seen whether the firm can continue to generate outperformance. Larry Swedroe is director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.

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