American Funds - Is the Magic Gone?

American Funds are one of the three largest fund families in the U.S., along with Fidelity and Vanguard. Their once stellar performance seems to now be lagging as investors pulled $19 billion out of the fund family in the first half of 2010, according to Investment News Magazine. Is the magic gone? I think not, and here's why.

A brief history of American Funds
American is one of the nation's oldest mutual fund families, serving investors since 1931. Their active funds are distributed through financial advisors because they "believe in the value of professional advice." They charge their investors sales loads and ongoing 12b-1 fees to compensate brokers who sell them.

There are several differences between American funds and other loaded fund families. American grew to become one of the largest fund families by having outstanding performance. Through 2008, in up markets and down, American Funds beat their peer averages soundly. In my opinion, they did so by having a focused long-term approach. While their funds are active rather than passive index funds, their turnover is low which keeps hidden costs low. Taking out the sales loads, their expense ratios are very low for active funds.

I've written about American Funds several times questioning whether they could maintain their large positive margin over their peer averages. Taking the sales loads into account, I even noted that their overall performance is similar to Vanguard index funds. The fact that I didn't recommend American Funds garnered some hate mail from advisors, though not at the level of my annuity articles.

American Funds today
According to Investment News Magazine, American Funds represented seven of the ten funds with the biggest outflows in the first six months of the year. American's $19 billion outflows contrasts to inflows of $0.4 billion for Fidelity and a whopping $39.9 billion inflow for Vanguard. According to Morningstar, American Funds underperformed their category average by 0.1 percent in 2009, and 0.4 percent through June of 2010. This hardly seems like a large number, but keep in mind that mutual funds overall underperform the market.

American bond funds in particular have performed poorly with Morningstar performance ratings of 2.3 for taxable bonds, and 2.4 for muni bonds. A rating of three represents an average performance versus peers.

Why I think the magic isn't gone
A slight underperformance for the past 18 months doesn't mean it's time for American to take a dirt nap. I suspect that American Funds are likely to beat their category averages going forward, though I am sticking to my guns about the superiority of low cost diversified indexing.

American funds are still focused and have lower costs than a lot of the nasty index funds out there. I certainly like their approach more than many so called index funds using leverage and inverse benchmarks.

It's not that I think American funds have lost their magic, I suspect they never had it. The way I see it is that their disciplined approach, combined with a little luck, is what gave them the strong performance. But luck is a fickle thing, and it appears to have turned against them over the past 18 months. I suspect it will level out in the long run and their low costs and disciplined approach will have them beating their category average again going forward.

Advisors usually sell what has performed well in the past, so American's luster will likely be restored with advisors as soon as their performance improves. That said, investors may not be so easy to win back, as they are getting wiser and pouring more of their money into low cost funds. This often means bypassing the advisor altogether, which could spell trouble for an active fund family relying exclusively on advisors as its distribution channel.

My Advice
I'm unlikely ever to recommend a fund with a 12b-1 fee, though if I ever were to, it would be an American Fund. But if your advisor is telling you to get out only to turn around and sell you another loaded fund, you should question the motivation behind the advice. Jumping out of American Funds' frying pan into the fire of the next hot flavor of the month mutual fund can prove to be costly. However, if you are considering replacing your American Funds with broad low cost index funds from providers such as iShares, Fidelity, State Street, and Vanguard, I think the odds are in your favor.

MORE ON MONEYWATCH
Largest Fund Families
High Yields - Why Your Advisor Suddenly Wants More Risk
DFA vs. Vanguard - Which is better?