Capital Group Defends Active Management
September 19, 2013
Comparing Fund Companies
Capital Group (CG), the owner of American Funds, held a very rare meeting with the media, as reported by Bloomberg, Reuters and The Financial Times. What undoubtedly prompted the meeting:
The firm’s American Funds have lost $242 billion to withdrawals since the end of 2007, while Vanguard Group Inc., the largest index-fund provider, has attracted $607 billion, according to Morningstar Inc.
One way to counteract this shrinkage of AUM is to go on the offensive and promote an apparent dominance of active management over indexing. To that end:
Capital Group, based in Los Angeles, in a study released today, argued that its stock-picking mutual funds outperformed their benchmark indexes in the majority of almost 30,000 periods examined over the past 80 years. That included 57 percent of one-year stretches, 67 percent of 5-year periods and 83 percent of 20-year ranges.
The Capital Group study examined 17 of the company’s mutual funds that invest in equities or both equities and bonds. It measured their performance over every one-, three-, five-, 10-, 20- and 30-year period, on a rolling monthly basis, from Dec. 31, 1933, through Dec. 31, 2012.
Should investors care? Not really, because over such a long period of time, and especially in the last 15-20 years, the nature of investing has changed dramatically. There is more information available about both stocks and bonds, and this information is propagated with higher speed to a much broader investment audience, which makes markets more efficient and the job of an active manager more difficult. In addition, composite investment vehicles other than mutual funds — exchange-traded products (ETPs), tracking an ever-expanding spectrum of indices — have become readily available.
Finally, comparing just the returns of a mutual fund against those of its benchmark is largely meaningless because it does not fully adjust for the fund’s risk. Alpholio™’s methodology seeks to overcome this limitation by providing a dynamic, custom reference portfolio of ETPs for each analyzed mutual fund. Only the excess return of the fund over that of its reference portfolio, i.e. the RealAlpha™, counts.
According to the Bloomerg article:
Capital Group’s largest offering, the $123 billion Growth Fund of America, has seen its assets drop 31 percent in the five years ended Aug. 31. During that time the fund returned an annual average of 6.4 percent, compared with 7.3 percent for the S&P 500.
As an update to an earlier Alpholio™ post, here is how the risk-adjusted performance of this fund looked like since early 2005:
Despite a recent improvement, the fund’s performance in the last five years has been unimpressive. Small wonder many investors voted by withdrawing their assets.
July 26, 2013
Analysis of American Funds Growth Fund of America
A recent three-part article from Morningstar compares American Funds with Vanguard. The first part claims many similarities between the two firms with respect to:
- Long employee tenure
- Staid funds
- Low portfolio turnover
- Multiple investment managers
- High diversification
- Risk aversion
- Strong market correlations
This is despite all major differences — unlike American Funds, Vanguard
- Focuses on indexing
- Sells funds directly to retail investors
- Has plenty of bonds funds
- Offers ETFs
- Services 401(k) plans
- Is prominently featured in the media
The second part proposes several explanations why, despite those similarities, US equity American Funds have collectively suffered net outflows of $110B, while a single Vanguard Total Stock Market Index (VTSMX) fund gained $45B in net inflows over the trailing three years. Apparently, the main reasons were poor distribution and marketing decisions, and not a poor average fund performance, despite the latter being deficient by an annualized 0.5% vs. VTSMX over the last five years. This indicates that despite a roughly equal performance over the last ten years, and a superior performance over a fifteen-year period, the glory days of American Funds may be over.
The third part delves more into performance and tries to massage the numbers to support the thesis of equality. First, a 25-year time frame of analysis is picked. This is convenient because, as part two shows, the more recent performance of American Funds has been deficient.
Next, seven unidentified American Funds and ten unspecified index funds are chosen for performance comparison. Index funds from firms other than Vanguard are used, apparently to alleviate a low-cost advantage the latter have. Given that the analysis period starts in 1988, only three existing Vanguard index funds are applicable: 500 Index (VFINX), Extended Market Index (VEXMX), and Small Cap Index (NAESX). All these are Investor share class, which means the comparison does not take advantage of even lower cost Admiral shares that were introduced in 2000 (switching between share classes of the same fund is a non-taxable event). With all that, the selection of funds for the comparison is questionable.
Subsequently, a maximum 8.5% front load is applied to American funds. This is fair because an investor could not have purchased these funds without such a load 25 years ago. However, then an “industry standard” 1% fee is charged annually to index funds. This is ostensibly done to account for the lack of “financial advice” with index funds. This “equalization” approach makes no sense because the front load is paid only once, while the financial advice fee is charged annually and thus has a compounding effect. A one-time financial “advice” provided 25 years ago (i.e. “I recommend that you should buy this great fund [on which I get a commission]”) is not the same as continuous advice on asset allocation (typical with passive investments) provided over the 25 year period. Apples to oranges.
Next comes a simplified accounting for taxes, which, for the lack of data, extends the average annual performance penalty for American Funds recorded in the last 15 years to the entire 25-year period. It is unclear if this analysis takes into account the reinvestment of residual after-tax distributions into each fund (this is what an investor would do, absent any external funds to pay taxes). Nevertheless, it is at least an attempt to take an important performance factor into account.
In the end, were it not for the recurring management fee penalty, index funds would have clearly come on top. In addition, this performance comparison does not take into account the volatility of each fund. At a minimum, what were the ex-post Sharpe Ratios for each fund calculated over the entire 25-year period? The article does not say.
In sum, it looks like the article started with a thesis of an apparent equality between the two fund firms, and then concocted a cryptic and incorrect performance analysis to support this thesis. That is regrettable.
July 24, 2013
American Funds Growth Fund of America (ticker symbol AGTHX) is a mutual fund with approx. $116.8 billion in assets managed by a team of a dozen portfolio managers. The fund is one of the largest in the industry. Currently, Morningstar rates the fund Three Stars / Bronze in the US OE Large Growth category and says “This fund’s large asset base weighs down on its potential.” Let’s appraise the fund’s performance using the Alpholio™ methodology.
First, the total return chart, which reflects a reinvestment of all distributions into the fund and each member of the reference portfolio, respectively:
The chart shows that the fund outperformed the reference portfolio from early 2005 through the first half of 2008. After that, the fund’s performance was comparable to that of the reference portfolio.
This is further illustrated by the cumulative RealAlpha™ chart:
An investor who bought the fund at the beginning of 2005 lost practically all of the cumulative RealAlpha™ by the end of 2008. Subsequently, the trend of the cumulative RealAlpha™ was flat to negative.
The overall performance statistics are unimpressive:
The fund’s volatility, measured by a standard deviation of monthly returns in the entire analysis period, was slightly higher than that of the overall stock market. The volatility of the reference portfolio matched that of the fund, which tends to indicate that the fund was well diversified and held securities present in the reference exchange-traded products (ETPs). The overall discounted annualized RealAlpha™ figure was close to zero, which underscores the difficulty in differentiating a fund of such an enormous size (see the recent article on “active share” from Barron’s).
The following chart demonstrates the use of smoothed RealAlpha™ to automatically generate a hypothetical trading signal:
The analysis starts with an assumption that the investor initially bought the fund in early 2005 and intended to hold this investment indefinitely, i.e. at least through early 2013. The blue curve depicts the cumulative RealAlpha™ in that entire period. Since there is some degree of high-frequency oscillation in that curve, its longer-term trend can be elicited from a smoothed approximation by an exponential moving average (EMA), depicted by the green curve. Subsequently, a simple decision criterion is applied to determine whether the investment in the fund should be retained. As long as the fund generates positive monthly increments to cumulative RealAlpha™, the investment in the fund is considered beneficial. Conversely, if the fund’s cumulative RealAlpha™ begins to consistently decrease, the investment is no longer considered attractive.
The signal would allow the investor to avoid a period of the fund’s underperformance from the end of 2008 through the third quarter of 2011. Please note that the most recent positive performance trend of the fund may not be sustained in the long run, as the cumulative RealAlpha™ curve started to turn down in the last couple of months.
The following chart shows the major investment “themes” of the fund over time:
In the analysis period, the fund held equivalent equity positions in JKE (iShares Morningstar Large-Cap Growth ETF; average weight of 24.6%), IVE (iShares S&P 500 Value ETF; average weight of 17.1%), IGE (iShares North American Natural Resources ETF; 9.8%), IWP (iShares Russell Mid-Cap Growth ETF; 9.1%), and VHT (Vanguard Health Care ETF; 6.2%). The cash equivalent position was represented by SHY (iShares 1-3 Year Treasury Bond ETF; average of 11%).
For clarity, smaller reference positions are collectively represented by the Other category in the chart. For example, this category includes an equivalent position in EWJ (iShares MSCI Japan ETF; average weight of 3.9%). This position implies that while the fund may not have actually held any stocks of Japanese companies, it held securities with a significant exposure to the Japanese market, such as US-headquartered multinationals. Similarly, the fund had an equivalent position in EWT (iShares MSCI Taiwan ETF; 2.9%). The fund may invest up to 25% of its assets in securities of foreign-domiciled issuers.
The above analysis demonstrates that, for the most part, the performance of this large fund could have effectively been replicated by a relatively small collection of ETPs. While the current expense ratio of this fund is a comparatively low 0.71% vs. the 1.25% average in its category, class A of the fund’s shares is burdened with a 5.75% front load. Prospective investors should take this sales charge into account along with the RealAlpha™ statistics of the fund when making an investment decision.