Size-induced large-cap focus could have benefits, though, especially these days.
By Kevin McDevitt, CFA | 04-11-11 | 06:00 AM | Email Article

After suffering $50 billion in 2010 outflows, one might conclude that asset bloat is less of a concern for American Funds today than it had been in the past. But it still remains an issue.

Kevin McDevitt, CFA, is a senior manager research analyst for Morningstar.

Even though American has experienced greater outflows (more than $80 billion through February) than any other family over the past two years, the firm's overall assets under management have recovered quite nicely, dwarfing what it has lost in redemptions. Total assets plummeted to $636 billion in February 2009 after peaking at $1.2 trillion in October 2007. Since then, total assets have recovered to $982 billion, a gain of nearly $350 billion.

That has occurred despite not just net redemptions, but also the family's generally middling relative returns in 2010. Last year the average American equity fund landed in its category's bottom half.

Nevertheless, a scorching rally can make up for a lot. The S&P 500 Index has roughly doubled since the market bottomed on March 9, 2009. This has re-flated American's asset base and leaves it second in size only to Vanguard, which has nearly $1.3 trillion in mutual fund assets under management.

No Precedent for Closure
Unlike index-king Vanguard, though, all of American's assets are actively managed, making asset size a potentially greater hindrance. Even so, Vanguard has been more responsive to size, closing four of its actively managed funds to new investors as they have grown. In contrast, even though it runs several of the largest actively managed mutual funds, American has never closed any of its offerings.

In general, closing a rapidly growing fund, or one that is in danger of becoming unwieldy, is often in the best interests of shareholders. It keeps the asset base at a reasonable size, allowing a fund to continue executing its strategy unencumbered. Plus, because inflows often spike during market rallies, the manager of a closed fund isn't forced to keep buying securities as valuations become inflated.

Directors: Being Unaffiliated May Not Be Enough
While it's possible that American could eventually shift course and close its first fund, the prospect looks unlikely. Part of that owes to precedent, but it also stems from attitudes on American fund boards. American deserves credit for the fact that independent directors claim 75% of board seats, including every board chair. However, even though these board members are unaffiliated with the firm, that doesn't necessarily mean that they have always acted as forcefully as they might have on shareholders' behalf.

This came up after we recently spoke with two of American's independent directors. Both said that asset size was not a problem for the firm. One board member then went a step further, saying that the boards have never seriously considered pressing for the closure of any fund.

Implications: Whatever the Future Holds, It's Going to Be Large (Cap)
So, what does it mean for American Funds if closure is likely not in the cards? For its equity funds, most of which are large-cap offerings to begin with, large-cap stocks will figure even more prominently in future portfolios, with less flexibility to take meaningful positions in small- and mid-cap issues.

This trend is already in place. Since 2002, large caps have become a greater percentage of American equity portfolios as assets have grown. The impact of asset growth is clearly seen for  American Funds Growth Fund of America . The fund had less than $40 billion in total assets for most of 2002. Although total assets have dropped from a peak of $202 billion in October 2007, they have still more than quadrupled since then to more than $165 billion.

When GFA's assets stood at $40 billion in 2002, the fund had about 20% of its portfolio in small- and mid-cap stocks. At the end of 2010, the fund had just 10% of its portfolio in small- and mid-caps. The effects of asset growth show up in other ways. In 2002, the fund had eight comanagers and held fewer than 200 stocks. The fund has since added nearly 100 equity holdings and four portfolio managers.

Asset growth has had an equally dramatic impact on  American Funds Smallcap World . The fund's asset base has ballooned to more than $22 billion from $6.5 billion in 2002. During that time, the fund's small-cap weighting declined to just 36% of the equity portfolio from 53% in 2002. Mid-cap exposure has filled the vacuum, but the proportion in large caps has more than doubled, too, over this stretch to nearly 9% of equity assets.

Nevertheless, Smallcap World has still enjoyed strong performance versus its broad, generally large-cap-focused, world-stock peers since 2002. That's because small- and mid-cap stocks have generally enjoyed better returns than large-cap issues during that time.

The good news for most American equity funds, though, is that large-cap stocks appear to offer better relative value versus small-cap stocks than they did in 2002. The estimated 17.3 forward P/E ratio on the small-cap Russell 2000 Index is more than 20% greater than the 14.1 forward P/E on the S&P 500 Index. By contrast, small-cap stocks traded at a more than 20% discount to their large-blend counterparts in 2002. So, while some of American's large-cap funds have struggled in recent years, relative performance should improve when large caps eventually return to favor.

The longer-term problem, though, is that American's equity funds may not have much choice in where they are positioned along the market-cap ladder. Plus, there are capacity limits to consider even for American's multimanager model. There are only so many market-beating investment ideas out there, and it becomes more difficult for any one of them to "move the needle" as assets grow. At some point, there could be diminishing returns from adding new managers and more stocks to a fund. Closing some of its funds would potentially save American from having to make further accommodations for size. Plus, it would likely benefit shareholders.

 

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Kevin McDevitt, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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