What's Next for American Funds

To borrow a description from Sir Winston, the American Funds family is a riddle wrapped in a mystery inside an enigma. The firm manages assets greater than the annual economic output of Australia, representing the savings of some 50 million shareholders, and its name is a touchstone for financial advisers everywhere. But despite its omnipresent role in the nation's retirement savings, the family maintains a veil of secrecy over its inner workings and the brain trust that runs the funds.

But if money equals power, it hasn't corrupted Capital Research & Management, the shy advisory company that runs these funds. Capital's people today work in the same manner that they have for nearly eight decades -- head down and nose to the grindstone. That's how American has delivered the results and garnered the cash to become the largest mutual fund family in the world, with more than $1.1 trillion in assets under management.

The American Funds' consistently superior track record is virtually unparalleled. All 11 of the firm's stock funds with ten-year histories have above-average total returns in their categories for the past decade. A majority of American's stock funds have landed in the top 25% among their peers over the past three years.

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Driving that performance is a philosophy of deep research and investing for the long term. That may seem like common sense, but Capital Research's innovation has been to let multiple managers of each fund run portions of assets independently -- mimicking the nimbleness and efficiency of much smaller funds while working on a supersize scale.

Please, no publicity

Few of American's millions of shareholders recognize the name Capital Research & Management, which is exactly how the firm's leadership likes it. You could drive by the company's posh Los Angeles headquarters, in a 55-story skyscraper, and never know it. The building's owners offered to put Capital Research's name on the structure when it leased the top five floors, but tru to character, the firm declined the free publicity (today the "Bank of America" logo appears on the building's exterior).

Capital's roots trace to an Alabama architect named Jonathan Bell Lovelace, who made a bundle in stocks in the 1920s and deftly exited the market before the 1929 crash. In 1931, Lovelace founded a firm to provide financial advice to California companies. His firm soon took over several exchange-traded closed-end funds, including Investment Company of America, which Capital converted to a regular mutual fund in 1934 and still runs today.

Capital's defining moment came in the late 1950s, when it developed the multiple-manager approach. Because assets are divided among managers, no one person handles more than, say, $10 billion to $20 billion, and each can pursue his or her best ideas without having to persuade the whole team. Plus, a single person's gaffes or windfalls can't dominate a fund's results. "The fund shareholder gets a much more stable ride because of the lending of different approaches," says Dale Hanks, a Capital vice-president.

Without that innovation, Capital probably couldn't manage the amount of money it does in so few funds. Measured by total mutual fund assets, Vanguard is a close second, with a hair more than $1.1 trillion, and Fidelity ranks third, with $903 billion. But Vanguard runs more than 100 funds, the largest of which are tied to indexes. Fidelity spreads its assets among nearly 200 funds, with several of the largest being closed to new investors.

By contrast, American runs just 27 funds, 15 devoted entirely or partially to stocks, plus nine target-date retirement funds, which invest in other American funds. Although American manages ten of the nation's 17 biggest stock funds, including the largest -- Growth Fund of America, with $185 billion in assets -- the firm has never closed a fund to new money and says it has no plans to do so. Instead, whenever a fund's assets swell to gargantuan levels, Capital adds another manager to the fund's roster. That has helped it avoid the problems that tend to come with outsized assets, such as managers running out of ideas for new money or being unable to invest in smaller companies.

The brain trust

A relentless focus on hiring is also critical to Capital's stellar results. The firm increases its staff of investment decision makers by about 8% each year. It now employs 105 analysts and 68 portfolio managers across offices in London, Geneva, Tokyo, Hong Kong, Singapore and five U.S. locations.

Selective doesn't begin to describe the hiring process, which can easily last a year. Dozens of one-on-one interviews gauge a candidate's intelligence and personality -- Capital abhors the "star manager" culture and courts modest types. It's a coveted employer in the industry, and employees rarely leave; on average, Capital's portfolio managers have been with the company for 24 years.

Once they make the payroll, professionals are expected to be bold and creative. Managers are encouraged to stick to their guns when stocks they like get pounded by the market. All analysts run money alongside portfolio managers, so many remain analysts and cover the same companies for decades. "I'd say we know our companies better than anyone else," says Gregg Ireland, a manager for Growth Fund of America and American New Perspective.

Why not close?

Concerns about asset growth haven't stemmed the enthusiasm of advisers and brokers, among whom the American funds are wildly popular. "American Funds is truly a world-class organization," says Mark Schlafly, president of FSC Securities. "It's a group you want to be associated with." Michael Ward, an adviser with LPL Financial, says the funds' consistency and low expenses are typically the top reasons advisers love them. On average, the Class A shares of American's diversified domestic-stock funds charge 0.61% in annual expenses -- less than half the average for all diversified U.S.-stock funds.

Criticism of the shop's refusal to close funds is nothing new. But some fund watchers think this time is different, particularly because assets have ballooned by more than 200% over the past seven years. Morningstar analyst Greg Carlson, for one, thinks that endlessly adding new managers may eventually lose its effectiveness. Already, for example, 11 managers, plus a group of analysts, pick stocks for Growth Fund of America.

Capital's most recent idea for handling its own girth was to divide itself in two. The split, which was finalized in 2006, parceled out investment-management responsibilities to two operationally independent entities: Capital World Investors and Capital Research Global Investors. Each invests according to its own managers' and analysts' ideas and research. Some funds are run entirely by one or the other, and a few are run by both.

Ask an insider why Capital Research doesn't close funds and you'll be told that the firm is serving the best interests of its shareholders. "I think American sees its role as helping as many people with their retirement savings as it can," Carlson says. "Although, obviously, there's a tremendous amount of money to be gained."

Hanks fairly points out that the negative effects of closing funds could outweigh the benefits of keeping them open. As baby-boomers start cashing out retirement savings, he says, closing to new investors could cause a fund to pay out more than it's collecting in new assets. In that case, managers might have to sell stocks at unfavorable prices simply to generate cash. "You're just swapping one set of problems for another," he says.

Ultimately, investors have to rely on Capital's remarkable record of consistent returns, its unique management style and its vow that if assets ever truly overwhelm its system, it won't hesitate to close funds. Because its funds come with sales charges, they aren't appropriate for do-it-yourself investors. But American offers compelling options for investors who work with an adviser, particularly considering its funds' ultra-low expenses. Asset size, however, continues to be a threat worth monitoring.

Then again, looking for innovative solutions to the old problem of outsized assets seems to be embedded in the family's DNA. "The assumption from the outside world is that there's only one option -- it's like a toggle switch, and you're either open or you're closed," Hanks says. "Closing a fund is never off the table, but it would be one of a range of options." Whether the firm will continue to invent successful alternatives is part of the American Funds enigma.

A GUIDE TO AMERICAN'S BIGGEST STOCK FUNDS

Growth Fund of America, $185 billion

Buys large, growing, mostly domestic companies. Before 2007, it was in the top 20% of its category for nine straight years. In the first six months of 2008, the fund lost 7%, beating most peers and Standard & Poor's 500-stock index.

EuroPacific Growth, $113 billion

Invests in large foreign companies, both undervalued and fast-growing, with a focus on Europe. Beat 60% or more of similar funds in seven of the past ten calendar years, and year-to-date, with a loss of 10%, is slightly ahead of similar funds.

Capital World Growth and Income, $107 billion

Invests in top-yielding blue-chip stocks from around the world. Beat 70% or more of similar funds in each of the past eight calendar years. Year-to-date the fund has lost 10%, matching the loss of the MSCI World index.

Capital Income Builder, $106 billion

Owns high-yielding stocks and high-quality bonds from around the world. The fund delivered positive returns in each of the past eight calendar years, although it lost 8% in the first six months of 2008 and trailed most of its peers.

Income Fund of America, $78 billion

Buys domestic and foreign high-yielding stocks and bonds of varying quality. Beat 88% or more of similar funds in six of the past ten calendar years, although year-to-date it is down 9% and is lagging 83% of its peers.

Investment Company of America, $77 billion

Looks for large, growing, mostly domestic companies selling at cheap prices. Has zigzagged relative to peers over the past decade, although year-to-date the fund is holding up better than 70% of similar funds, with a loss of 11%.

Washington Mutual, $70 billion

Invests in large, undervalued companies that pay dividends, avoiding alcohol and tobacco companies. The fund has waffled over the past decade, coming out about average for its category. In the first half of '08, it has matched the S&P 500's 12% loss.

New Perspective, $55 billion

Buys large, out-of-favor companies in North America and Europe and tends to hold a lot of cash. Has outpaced at least half its peers in eight of the past ten calendar years. Year-to-date the fund has lost 9%, beating 79% of its peers.

American Balanced, $55 billion

Owns cheap stocks of big, mostly domestic companies and high-quality bonds. Has outpaced at least half its peers in seven of the past ten calendar years, but year-to-date it has surrendered 8% and is lagging 70% of similar funds.

Fundamental Investors, $51 billion

Seeks overlooked, growing companies, U.S. and foreign. Beat 60% or more of similar funds in eight of the past ten calendar years. In the first six months of 2008, the fund lost 7%, putting it in the top 10% of its category.