American Funds Demonstrate the Risk of Active Management
The cover story in Barron's last week was a profile of American Funds, which focused on something I wrote about a few weeks ago: the rather shocking amount of money that has flowed out of the fund complex over the past few years -- a surprising reversal of fortune for a firm that took in enormous amounts of money in the first few years of this century.
None of the American executives that were interviewed betrayed a great deal of concern about their deteriorating market share, but the fact that the notoriously publicity shy firm was willing to spend so much time with a reporter indicates otherwise.
While I don't doubt that the firm's woes are cyclical to some extent, I do believe -- as I noted earlier -- that the industry is moving away from them. Further, their troubles highlight the perils -- for both fund investors and fund managers -- of relying heavily on active management.
The article places the blame for American's cash flow troubles on the rather lackluster performance of the firm's funds since the recent market crash (which my colleague Larry Swedroe wrote about recently). That's undoubtedly part of the problem, even as one executive blames the advisors who sell their funds for overstating the firm's ability to "defy gravity." (While he might have a point, I can't find any evidence that the firm was attempting to temper investor expectations during the heady days of the early- to mid-2000s.)
The reality is that the remarkable amount of money that flowed into their funds in the first half of the previous decade was the result of a perfect storm of conditions. First, their funds navigated the bursting tech bubble better than most, resulting in very strong performance relative to their peers. Secondly, their funds were made all the more attractive by the mutual fund timing scandal. Nearly every single one of their primary competitors among broker-sold funds was implicated in one way or another in the scandal unearthed by then-New York Attorney General Eliot Spitzer, which left American Funds as the finest house in a rapidly-deteriorating neighborhood.
But now American is being victimized by both fading memories and performance, which isn't particularly shocking. Active management has long been a "what have you done for me lately" game, in which investors and the brokers that advise them are constantly chasing after whatever funds and strategies have fared best in the recent past. When they perceive that your ability to add value has vanished, they will too.
The executives interviewed do a fine job of explaining the reasons for their recent stumbles. Chairman Jim Rothenberg acknowledged that "the firm underestimated the economic rebound" as the recession bottomed out, and described how the recovery didn't unfold as they had expected, leaving the firm's funds underweight in sectors and stocks that subsequently outperformed.
True as that may be, it underscores the risk of active management. You're counting on your fund's manager to make those calls correctly, time and time again. The fact that it's nearly impossible to do so, combined with the severe performance penalty that looms as the result of a bad decision, explains why it's so difficult to outperform the market over the long-term.
These perils aren't limited to the equity markets. For instance, Barron's describes the recent problems encountered by American's Bond Fund of America. As the credit markets crumbled in 2008, the fund found itself "heavily loaded with corporate bonds," which resulted in a loss of more than 12 percent for the year.
While that performance was surely disappointing to its owners, perhaps it shouldn't have been surprising. Bonds, of course, are attractive primarily because of their ability to stabilize portfolios when stocks are declining. The Bond Fund of America, however, is managed in a style -- as described by one of its managers -- such that it tends to "do well when equity markets are doing well" and performs "poorly when equity markets" stumble. That's a bit of a counterintuitive approach, but one you have to live with if you put your fund in the hands of an active manager.
Finally, one of the constant criticisms of American Funds during their heyday was the fact that they never closed any of their funds as they reached gargantuan size. That size, of course, severely restricts the pool of stocks that fund managers can choose from, which makes it very difficult to add value, and increases the likelihood that the fund is nothing more than an expensive closet-index fund. But while performance may suffer as a fund's assets expand, that growth results in increased revenue for the fund manager -- one of the fundamental conflicts of interest that active fund investors must contend with.
American Fund executives always countered that their decision not to close their funds wasn't motivated by their own self-interest, but by the fact that their management system -- which relies on small teams of managers responsible for slices of each fund's assets -- protected the funds from the harmful impact of their size. I've always regarded that as a rather specious claim, and it's possible that their funds' recent troubles reveal that their system isn't as fool-proof as they would have investors believe.
But what's even more disingenuous is the false choice that fund manager Robert Lovelace offers when he argues that their system for managing fund size is superior to that of many of their competitors, who, he claims, close one fund and open another with a similar strategy with higher fees.
Those are the only two options if your goal is to grow fee revenue as much as possible. If, on the other hand, your primary motivation is to do what's best for your investors, a third alternative is to simply close the fund. Period. With no concern for replacing any revenue that you're foregoing.
The American Funds are some of the oldest in the industry. Many own fine long-term track records and are accompanied by relatively low fees. (There's doubtless a link there.) And if an investor is convinced that they want to bet on active management, they could do much worse than to choose one of their offerings. But as the firm's recent history indicates, there's simply no avoiding the fact that active management is accompanied by risks over and above concern for what returns the financial markets will deliver.
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