Sunday, August 10, 2008

Fund Watch, No. 1

This is about the American Balanced Fund, which is not an investment so much as merely a place to park cash.

These rants will be in no particular order:

If you drop $10,000 into this mutual fund, it immediately swallows 5.75% in fees, which investment companies call "loads." That leaves you with $9,425 exposed to the stock market's potential returns.

Or does it?

No. You don't need to look any further than the fund's name -- the "balanced" part -- to see that this fund invests in bonds as well as stocks. It turns out the fund has about 60% in stocks, 30% in bonds and 10% in cash.

"OK," you say. "Fine. So I have $5655 of my hard-earned $10,000 in the market. That's good. That's where the returns are."

Well, maybe. It certainly can be.

First, let's look at what the fund owns. We'll start by examining its top ten assets. All of these holdings are 1.5% to about 2% of total holdings. The number to the right is their year-to-date return.

IBM 20.6%
Wal-Mart 22.8%
Chevron -8.2%
GE -18.4%
AT&T -23.0%
Oracle 4.2%
Berkshire -18.3%
Treasurys 2.1%
Cisco -10.4%
Microsoft -20.4%

This chart makes one thing abundantly clear: The fund mangers ought to be thanking their lucky stars for IBM and Wal-Mart. Without them, the fund would be lagging the S&P.

IBM is, admittedly, doing great, but Wal-Mart is a perennial dog. The S&P 500 has blown Wal-Mart out of the water for the past five years -- it's notched a gain of +32.6% vs. a teeny +0.15% for the retailer. Wal-Mart has only shown life recently, as investors bought shares to hedge against a slowing economy. (When the economy starts to pick up, Wal-Mart will stumble as shoppers start to return to stores they actually like rather than a store they're being forced to shop at. (Wal-Mart's a good short at $58.)

This fund has $54.6 billion under management. Wal-Mart makes up 2% of that. In my mind, Wal-Mart -- except for the past six months -- is a wholly lousy place to invest. Assuming the fund has owned Wal-Mart for five years, which is likely given a cursory glance at its regulatory filings, then this holding alone has actually cost investors $311 million.

How can an investment that's in the black cost investors, you ask? Answer: When another comparible alternative could have made more for equal cost and risk. In this case, that's the S&P 500. And $311 million, amazingly, is the difference between Wal-Mart's crappy five-year return and the performance of the S&P. The fund managers might as well have bought the SPDR, which tracks the benchmark index, and left the retailer's shares in some other sucker's portfolio.

Without Wal-Mart and IBM, however, the fund would be down -13.2%, and that's worse than the S&P. But that's not really fair, because the fund does own IBM and Wal-Mart, and the top ten holdings are, in fact, beating the S&P by a factor of two. In a year like we're having, that ain't bad. (The overall portfolio isn't faring as well, though it's still better than the S&P)

But even so, looking at this fund's top ten holdings pisses me off. The fund has holdings up 20% in a bear market. What the hell is it thinking? Does it honestly think that those shares -- especially in those two megacap companies -- are going to go still higher? It ought to sell those winners, take the gains and start buying the losers -- which do have a legitimate shot at gaining 20%. Even if it's too chickenshit or tax-averse to do sell the winners, the fund is still sitting on $5.6 billion in cash, for heaven's sake! Warren Buffett's Berkshire Hathaway is a steal. GE is a good value. Or even Target, which is down -2%. Buy it now while it's cheap -- before the economy turns and people quit going to Wal-Mart. And those are just three stocks the fund already owns!

Oy. Let's look at sectors before I have an aneurysm.

SECTOR Weighting YTD
Software 5.24% 0.13%
Hardware 12.59% -4.91%
Media 3.94% -9.18%
Telecom 5.21% -17.28%
Healthcare 12.53% 3.86%
Consumer services 9.62% -0.10%
Business services 5.50% -2.52%
Financial services 9.62% -13.88%
Consumer goods 7.08% -6.50%
Industrial materials 15.62% -7.41%
Energy 11.54% -8.33%
Utilities 1.51% -8.02%

This was a lot prettier in Excel. Even so, it was still a tough chart to make anything out of because assets are so spread out. Investors should always remember Obermueller's Oscillation Principle: That which hits the fan will not be evenly distributed. And spreading out your portfolio too far can create its own risk: It may protect you a little in bad times, but it will hurt you in good times. (This is a good reason to invest in ETFs and not funds, but we'll get to that another day.)

Make sure you look at the sector breakdown for funds you're considering. Compare them to the fund's prospectus and to your investment objective. If you want growth and the fund is holding a lot of utilities, then it might not be the best match, as utitilies usually don't post much relative growth. Also sectors give you a rough idea of performance and potential. Only two sectors are lagging the S&P -- financial services and telecom.

Look at this chart, but don't stare. It's a little misleading. The weighted aggregate return for a portfolio containing this weighting of the sectors would be -5.6%. But the fund is down -9.1% for the year. That means it picked the losers in each sector -- which is different from "is picking" the losers, which would least imply some upside. If I were the fund manager, I would be selling healthcare and consumer services and buying phone companies and banks.

Besides its shattershot approach, I guess I really have five major problems with this fund.

I just don't like funds with front-end loads. The only way they work is if you hold the fund for a long time. This fund dings you for 5.75% right off the bat and charges an annual fee of 0.58% on top of that. (Which means you're going to need one heck of a first year -- at least 20% -- to beat the market and make back your fees).

If I absolutely have to pay a fee, I don't want it to be higher than the average 1.50% that ETFs charge. That means I have to hold this fund for at least six years. I don't like being forced into that kind of commitment.

I don't like "balanced" funds. If you're gong to invest in funds and want to own stocks and bonds, then pick a stock fund and a bond fund -- no investment can do everything. I'm 32 and have a long time horizon. My 401(k) is diversified, and my home and cash savings will vouchsafe some wealth. For my discretionary investment portfolio, I need to be investing in aggressive growth and value.

Bonds are safe, sure, but I have safety in other part of my portfolio, and bonds just serve to water down the returns. Bonds can be used to generate cash, but in this case they aren't even doing much of that: The fund yields a mere 3.2%; the S&P does 2.4% on its own, and it at least has the potential for additional gains. The only function bonds have in this fund is asset protection, which is not the purpose of discretionary investment at a young age. In this case, bonds just create an opportunity loss and force your equities to work harder to pick up the slack.

I don't like big funds with holdings in lots of big companies. Big companies, as a rule, lose ground far faster than they gain it. I also don't like big funds that own big companies and don't trade them. This fund owns 112 stocks and only turns 35% of the portfolio over in a year. An enterprising eight-grader could run this fund. If you're paying the managers to spot winners, make sure they're doing it.

I like transparency. I go the SEC web site and download filings to track holdings over time. Try doing this with "American Funds." I had to go to American Funds' site, fiddle around and find out that they're owned by The Capital Group Companies and then read a timeline on the history page to find the name "Capital Research and Management Company, which is how I found their ownership information. This strikes me as hinky. Plus, funds only have to report holdings four times a year. (ETFs report daily.)

I don’t like funds with crappy returns. If this fund is earning 6.8% a year and costing 2% to own, then I'm only up 4.8%. Inflation is going to erode 2.5%, so that brings my return down to 2.3%. We haven't talked about taxes. We should be talking about a jumbo CD or even some tax-free munis. They're going to do better than this fund, and we haven't even talked about the possibility of a down market.

Every mutual fund investment needs to be made after answering the following four questions:

1. What is my goal with this investment? Can the security I am considering meet that? How does its purpose line up with my needs?
2. Do I have confidence in management to deploy assets in such a way that balances prudence and potential to achieve the maximum return? Am I comfortable with the risk?
3. Do I know what the fees are? Am I bumping up against the law of diminishing returns?
4. Have I considered my exit strategy?

I said I wouldn't buy this fund. And I wouldn't. That's only my assessment based on my situation. But over the long term, this fund likely will serve its purpose. If your investment needs line up with its purpose and you hold it for a sufficient length of time, then you likely will have been served well. If not, hey, lesson learned.


Walden 316 said...

Excellent analysis. I am going to have to reconsider future investments in this fund.

thebrianmoore said...

I actually owned this fund for a few years. Sold it in '04 to raise cash to buy Rushwood. Some of the CDs banks were offering at the time outperformed it.