By Michael Shari
"Our flows were massive. We knew that would not last, and we were correct," says Jim Rothenberg, the gruff 64-year-old chairman of the executive committee at Capital Research and Management. He's talking about the flood of money that started rolling into the firm's American Funds family about a decade ago. These days, the hope is that outflows of cash don't last as long as the inflows did.
In 2000, American Funds' carefully-selected portfolios of mostly large-capitalization, long-term-growth stocks were the perfect destination for desperate investors fleeing flimsy dot-coms and shoddy Wall Street analysis. The Nasdaq fell 39% that year, while the firm's flagship Growth Fund of America /zigman2/quotes/208876675/realtime AGTHX -1.26% (ticker: AGTHX) rose 7.5%. The suddenly popular 70-year-old firm enjoyed an astounding net inflow of $372 billion from 2002 through 2007. Over a couple of prolonged periods, American accounted for all of the new inflows into the entire U.S. mutual-fund business.
More recently, however, investors have discovered that American isn't the answer in every U.S. financial calamity. The Growth Fund of America dropped 39% during the financial crisis of 2008, even worse than the Standard & Poor's 500's 37% decline. Overall mutual-fund assets at the Los Angeles-based firm crested at $1.17 trillion at the end of 2007—before plummeting to $744 billion a year later. Although asset levels, aided by resurgent markets, have come back to about $1 trillion, the outflows continue: Investors pulled out $141.64 billion between Jan. 1, 2008 and the end of February of this year—about $55 billion of it in 2010.
While the outflows aren't life-threatening, they do reflect mediocre performance, which has been a jolt to a privately held firm that champions its active-management principles above all else. Its founder, financier Jonathan Bell Lovelace, bought a fund company in 1932 that was invested in just three stocks, General Electric /zigman2/quotes/208495069/composite GE -0.20% (GE), Westinghouse, and S.S. Kresge (now dissolved into K-Mart). Not long afterward, Lovelace advised Walt Disney to take his cartoon company public, which he did early in the Great Depression.
Ever since, American Funds and its parent, Capital, have promoted investment research that seeks long-term values; it let analysts oversee client portfolios decades before the practice became popular at other money managers, and has compensated them according to their long-term picks. It's a serious business at American, where everyone starts as an associate, and successful analysts tend to embrace the team culture and stay for decades. One researcher recalls getting reprimanded by a more senior colleague for referring to a long-term stock recommendation as a "play on natural gas" in a meeting.
From its West Coast roots, American has always gone its own way, and Rothenberg insists the firm has no intention of changing its old-school approach. American, which sells exclusively through financial advisors, runs just 44 funds, versus Vanguard's 170. It has eschewed asset-allocation and long-short funds as well as exchange-traded and index vehicles. American doesn't offer an emerging-markets fund, even though it's one of the leaders in international institutional management and it never closes funds, leading to the creation of several huge, cumbersome entities that are unpopular with some advisors. Growth Fund of America now weighs in at $164 billion, and the EuroPacific Fund /zigman2/quotes/203439887/realtime AEPGX -0.78% (AEPGX) at $109 billion.
In a rare interview at his small office in the Bank of America tower overlooking downtown Los Angeles, Rothenberg tells Barron's that the 40,000 individual investors in American Funds would never understand "the modern stuff" and "the fancy things" that other fund families are marketing, and would never be able to tolerate the volatility of emerging markets. He professes not to care that much about fund flows, and is much more focused on American's long-term performance. He doesn't follow money-management fads.
"Remember what will happen to you when you own that index fund in the next crisis. It will go down a friggin' lot," says Rothenberg, a Harvard Business School grad who joined the firm in 1970 and has been its senior executive for seven years. "The hope is that all these asset-allocation programs and the like will get you protected at the right time. I would say a worse swear word to its probability of happening."
A plainspoken former analyst who tracked Xerox and Kodak, Rothenberg sees signs that large-cap stocks, the firm's forte, are coming back. American favors some multinationals that have reasonable price/earnings ratios and solid dividend yields. Most are more global than the U.S. economy because they make and sell their goods and services around the world. Since the crash of 2008, these companies have cut costs, dramatically improved earnings, and now are using the cash flow to buy back stock or pay dividends. As a result, "after a lot of years in which they were not all that exciting," some of American's biggest funds, like the $52-billion Washington Mutual Investors /zigman2/quotes/208118063/realtime AWSHX -0.47% Fund (AWSHX), have begun to outperform again.
"Do you want to own a bond with less than a 3% coupon for 10 years, or do you want to own a good-quality company with a 3.5% yield and a growing dividend? To me, it's something of a no-brainer," says Rothenberg.
If you are a contrarian seeking an out-of-favor management style (active and geared to top a benchmark) focusing on an out-of-favor sector (large-caps), an American Funds' offering like Washington Mutual could be a savvy bet. If you're not, move on.
The firm remains Barron's top-ranked mutual-fund family over 10 years of performance across several different types of funds, according to figures compiled by Lipper (" The Best Mutual Fund Families ," Barron's , Feb. 7). But it falls to 24th place over the shorter five-year interval, and then to 49th for 2010. Barron's rankings are based on a sampling of funds but a broader ranking shows the same trend. In another Lipper family ranking, it drops from the 37th percentile over 10 years to the 57th percentile for the last 12 months. Investors withdrew a net of $9.7 billion in January and February from American funds, maintaining the pace of last year. Overall, American has fallen to the No. 3 slot in mutual-fund assets, behind Vanguard and Fidelity, from No. 2 in 2007, according to Lipper.
"We disappointed people in the downturn in 2008-09, after we had done so very well in 2000-02," says Rothenberg. "We had all the raw ingredients, but somehow the chef messed up the soup."
Although reticent about discussing specific holdings, Rothenberg acknowledges that the firm underestimated the U.S. economic rebound. The funds prematurely lightened holdings of metal, mining and energy stocks in 2009. The portfolio managers were "thinking the economic recovery was going to be slow, and all that was going to be slow coming back. It didn't work out that way," says Rothenberg. Recent regulatory filings show that Growth Fund of America, of which Rothenberg is a portfolio counselor, sold its stake in ExxonMobil last year, missing the stock's subsequent advance.
In the midst of the crisis, Growth Fund had 6.2% of its holdings in financial-services outfits like Fannie Mae, Freddie Mac and Wells Fargo /zigman2/quotes/203790192/composite WFC +1.91% (WFC) at the end of May 2008. Chuck Freadhoff, a vice president of American Funds Distributors, says American's fixed-income analysts had identified subprime-mortgage problems in advance of the crisis but their views didn't carry over to the equity side.
On the fixed-income side, performance problems cropped up in the management of corporate credit, particularly in the Bond Fund of America /zigman2/quotes/208789680/realtime ABNDX +0.17% (ABNDX), which lost 12.2% in 2008. "I don't think our credit research did a great job," admits Rothenberg. Although it can invest in a wide range of fixed income, it was heavily loaded with corporate bonds. "Therefore, it has tended to do well when equity markets are doing well, and it has done poorly when equity markets did poorly," says Robert Lovelace, a grandson of the founder of Capital and a member of a committee that oversees the fund.
Senior management had seen this problem as early as 2003, but didn't start reducing the fund's holdings in corporate and other high-yield bonds and increasing its government bonds until 2006. But the process was slow, says Lovelace. "When 2007-08 hit, we regretted that it had not been done faster," he recalls. The fund returned 14.90% in 2009, but "that snapback was not as dramatic as it has been historically," he says. Bond Fund of America returned a middling 7.3% in 2010, and investors pulled out a net $5.84 billion, according to Lipper estimates. In contrast, rivals like Pimco and BlackRock were raking in money last year. Without elaborating, Lovelace says the firm has "made some critical manager changes" since.
SOME INSIDERS BELIEVE the firm has been hurt by the great expectations created early last decade. Kevin Clifford, president of American Funds Distributors, blames financial advisors who had oversold the funds as "able to defy gravity" based on their strong performance after the crash eight years earlier, which he dismisses as "foolish."
But Don Phillips, president of fund-researcher Morningstar, counters: "American bears some responsibility for this." The firm, he says, "aggressively hired wholesalers in the early part of the past decade, and I believe they brought in a shareholder base that didn't grasp the American Funds' philosophy as well as their long-term base did. The result has been the stream of recent redemptions."
The problems are worrisome since they comprise the second round of what Lovelace calls "two crises." The first was in the group's institutional unit. Rothenberg says the firm made the "mistake" of modifying its traditional investment strategies into "customized mandates" to fit the needs of specific pension funds, endowments and other institutions. In other words, a global strategy might be executed with European stocks excluded, to meet the wishes of the investor. As of Dec. 31, the institutional business had fallen to just $150 billion from $321 billion at its peak in 2006. "We did more of what they wanted, not what we do well," says Rothenberg, who seems determined not to make that mistake again.