Silence

American Funds: When Silence is Golden

Silence

The corporate parent of American Funds, the Capital Group Companies, recently broke its silence to defend its long-held practice of active management. As we noted in a prior article, they have been suffering the consequences of a long-term migration of investors from active to passive funds. Since the end of 2007, American Funds have lost $242 billion to withdrawals while Vanguard has gained over $600 billion. Their largest fund, the $124 billion Growth Fund of America, has suffered a 31% drop in assets during the five years ending 8/31/2013, during which the fund lagged the S&P 500 Index by about 0.9% per year.

When commenting on the on-going debate between active and passive, James Rothenberg, the chairman of Capital Research and Management, caught our attention when he said, “The only voice that’s been out there is the passive voice.”

Really? That indeed is a remarkable surprise to us. It seems that whenever we turn on CNBC, we are treated to an endless parade of pundits sharing their opinions about whether now is the right time to be in the market, which stocks we should be buying or selling, which country or sector is poised to take off, etc. As the estimable Bill Bernstein1 said, “Turn on CNBC and you’re faced with a lunatic asylum narrated by the Three Stooges.”

While there is no shortage of active voices, the frequency with which they contradict each other may lead one to regard them as irrelevant. In that vein, we wrote this article detailing a typical day on Yahoo!’s Daily Ticker where six different “experts” made six different predictions about the direction and magnitude of change in the market. Three said it would go up, and three said it would go down.

Returning to Mr. Rothenberg’s interview, he continued his tirade with an interesting statement. “We don’t entirely agree that the answer for all people is indexing. In fact, there can be a significant advantage to active investing.” We can only think of one person who recently said that index funds remain the best wealth management choice for all investors — Rex Sinquefield, the co-founder of Dimensional Fund Advisors (DFA) with David Booth and one of the pioneers of indexing. While American Funds has endured a harsh reversal of fortune, DFA has continued its exponential growth to the point of $287 billion under management as of 6/30/2013. Regarding the potential “significant advantage to active investing,” Mr. Sinquefield disposes of the occasional successes of active management as “random and not predictive of future success.”

In making his case for active management, Mr. Rothenberg cites rolling period historical data showing that their stock-picking funds outperformed their benchmark indexes in 57% of one-year periods, 67% of 5-year periods, and 83% of 20-year periods. We are not going to argue with any of their data or methodology, but we did take a closer look at their largest fund (the Growth Fund of America, AGTHX), which was the focus of the Bloomberg article referenced above.

For the thirty-nine full calendar years since its inception in 1973 through the end of 2012, AGTHX has provided an average alpha over the S&P 500 of 3.1% with a t-statistic of 2.1, indicating less than a 5% chance that luck is the explanation. This is something we see quite rarely among actively managed funds. However, before you run out to buy this fund, you may want to consider the distribution of this alpha—it is heavily tilted towards the early years of this fund. In particular, there were three consecutive years (1977-1979) where the alpha was 27%, 20%, and 27%. If we throw out the first decade of the fund’s returns (which may be reasonable since none of the fund’s current managers were managing the fund in that period), the average alpha drops down to 1.0% and the t-statistic of that alpha drops down to 0.7, which is well within the territory of luck.

The migration from active to passive is a global phenomenon. As this article in The Telegraph states, “A generation of young people has turned its back on the stock-pickers.” One young physician summarized it best when he said, “It became clear that there are hardly any decent fund managers around. I decided most of it was luck, rather than skill – so I’ve moved my money to save on costs.” In the UK, the potential cost savings are even higher than in the U.S. since the average actively managed fund in the UK charges 1.7%.

We have no doubt that the debate between active and passive will continue for a long time to come. However, as far as we are concerned, the debate was settled a long time ago. The academic papers cited in IFA’s Investment Policy Statement make a powerful case for passive.

1http://www.efficientfrontier.com/ef/401/onestep.htm