Feelings Not Mutual

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Feelings Not Mutual
Special Report: Banking & Finance Quarterly

When the tech bubble burst a dozen years ago, many investors were left reeling from heavy losses.

But not Capital Group Cos.

With its conservative investing philosophy, the manager of $1.1 trillion in mutual fund assets avoided getting tripped up when the economy swooned. Just as it had in the early 1990s, the late 1980s and many downturns before that.

In fact, for much of its 81-year history, the downtown L.A. company, one of the largest and most influential financial firms in the world, has outpaced competitors and produced consistently strong returns.

But now, Capital Group is facing perhaps its toughest test ever – one that is already leading to some considerable change.

Since the financial crisis began in 2008, Capital Group has sustained a mass exodus of clients as its performance has plummeted. Over the past three years, returns for its American Funds family of mutual funds have failed to beat more than half of its competitors, according to data provider Morningstar Inc.

Competing firms have introduced lower-cost funds in recent years, but Capital Group has resisted change even as investors have withdrawn $82 billion in the last year and $171 billion since 2008. Through a combination of bad investment results and redemptions, the firm has lost almost $500 billion, or one-third of its assets at its peak.

Capital Group was recently surpassed by Vanguard Group Inc. in Malvern, Penn., as the nation’s largest mutual fund company, its flagship fund was supplanted as the largest single mutual fund and a few months ago it also lost its title as the largest U.S. equity mutual fund.

“They will be less of a dominant force as the industry goes forward,” said Burton Greenwald, a mutual fund consultant in Philadelphia. “They had an exceptional run until the recent recession and they have since suffered dramatically.”

Capital Group readily admits that its funds’ performance of late has been disappointing and the firm acknowledges that recent outflows are due largely to investor dissatisfaction with returns.

But the company is starting to take action. It has pushed out underperforming employees and has restructured divisions. It is also expanding into the social media space in order to improve communication with financial advisers that sell its products.

Launching eight funds

Most notably, Capital Group is preparing to launch as many as eight funds that will allow investors to diversify their portfolios – a dramatic move for a firm that had introduced only 43 funds in its history.

Whether the steps will be sufficient to stem the record outflows, however, is uncertain, as Capital Group struggles with two unfavorable trends. The firm specializes in equities, which have been abandoned by many investors during the recent market volatility for the perceived safety of bonds; Capital Group also offers only actively managed funds, which are losing ground to index funds and other low-cost alternatives as investors question whether stock pickers can beat the market consistently.

“Investors’ tastes have diverged from what American Funds is offering,” said Kevin McDevitt, an analyst with Morningstar. “They are up against some difficult long-term trends. There have been times in the firm that they’ve faced adversity before … but it has been a long time since they’ve faced anything quite like this.”

Capital Group has never really catered to investors’ tastes.

The firm’s philosophy is based on the notion that investors need the help of professionals. And the firm, which sells its funds primarily through financial advisers rather than directly to the public, maintains that research-based stock selection can provide better than market returns over the long run.

“We have a fundamental, rock-solid belief in the way we manage money that it will deliver very solid return over time for shareholders,” said Chuck Freadhoff, the company’s spokesman.

That belief traces back to the company’s founder, Jonathan Bell Lovelace, an Alabama native who moved west to Los Angeles at the outset of the Great Depression and in 1931 launched the financial research firm that would become Capital Group. (See article, page 26)

Capital Group established a team-based style of fund management that has become one of the firm’s defining characteristics. For each fund, about six to 10 managers, or “counselors,” invest portions of the assets, while an additional two dozen or so analysts oversee a small portion of the portfolio. The conservative approach may cancel out hot streaks of individual managers, but historically it also has guarded against prolonged slumps.

“At some point, someone is going to be doing very well and someone is not going to be,” Freadhoff said. “When you have this approach you tend to reduce the volatility.”

The system also ensures that no single manager has a disproportionate influence over a portfolio’s investments. Individual acclaim has become a prominent theme in the fund world, which has produced big-name star managers such as Bill Gross, the co-founder of Newport Beach fund giant Pacific Investment Management Co. LLC, or Pimco.

Capital Group prefers its system for making it easier to ensure continuity if a manager leaves or retires, and it prevents stars from taking clients to another firm. (Downtown L.A. money manager TCW Group Inc. learned the pitfalls of the star system after its ugly 2009 divorce from Jeffrey Gundlach, who launched his own firm and took many clients with him.)

Keeping its investment professionals essentially anonymous fits squarely within Capital Group’s distinct culture of modesty, which starts with its whisper-quiet downtown office.

Capital Group occupies 12 floors of Bank of America Plaza on Hope Street and an additional four floors in a nearby high-rise, making it one of the area’s largest tenants, according to real estate experts. More than 1,000 of its 7,200 employees work there.

Yet the firm’s name is not on any buildings downtown – and that’s no accident. Despite offers from the landlord, the company opted against putting its overlapping-squares logo atop the tower, preferring to remain low-key. In an industry known for big paychecks and bigger egos, Capital Group has gone out of its way not to stand out.

“In the investment business you can come across an awful lot of people who are very self-centered, and you don’t find that so much at Capital,” said J. Dale Harvey, a portfolio manager for Capital Group for 16 years before leaving in 2007 to start his own firm.

Even its leaders, including Nonexecutive Chairman James Rothenberg and President Philip de Toledo, are low-profile in the L.A. business community.

None of the employees, even top executives, has a corner office; those spaces are reserved for conference rooms. When the firm moved into the building, it reduced office sizes and even lowered the ceilings to reduce any sense of grandeur.

Capital Group does not advertise and actively avoids press coverage, rarely making executives available for interviews. (The firm declined requests from the Business Journal for interviews with top executives for this article.) Freadhoff, the spokesman, said that in his 17 years with the company, he has issued just one press release: last November’s announcement of the death of the founder’s son.

Capital Group has opted instead to let its performance speak for the company. For years, that tactic proved fruitful.

Its funds on average returned a conservative but steady 6 percent annually during the 1990s. Its signature Growth Fund of America, meanwhile, ranked in the top 10 percent of its peers by one-, three-, five-, 10- and 15-year returns at the end of the decade.

The firm, never one to chase investment fads, largely avoided smaller technology stocks during the dot-com bubble and made it through the subsequent market downturn mostly unscathed. The investment community took notice.

“Capital really stuck to its knitting of doing things the old-fashioned way and when the tech bubble burst, that old-fashioned approach was absolutely rewarded,” said Harvey, who heads Poplar Forest Capital LLC in Pasadena. “Capital, by heeling to all the things it had always done, was in the position to grow quite rapidly.”

Capital Group’s assets under management exploded from $560 billion in 2000 to nearly $1.6 trillion in 2007, when it was the nation’s largest mutual fund company.

But that rapid rise had unintended consequences.

“Their performance in the early 2000s probably set unrealistic expectations for them as a firm,” McDevitt said.

Falling behind

The financial crisis punished many of its funds.

Growth Fund of America fell almost 40 percent in 2008, its worst loss in any calendar year. The mutual fund had ranked as the industry’s largest, with more than $202 billion under management, but amid heavy losses it was passed by Pimco’s Total Return Fund.

Capital Group has not recovered as well as many of its competitors. Since the market bottomed out three years ago, the firm’s funds have returned 19 percent annually on average, which is worse than 51 percent of its peers, according to Morningstar. That performance also lags S&P’s 29 percent annual return.

“The performance has not been as strong in the last three to five years,” McDevitt said.

Capital Group, which advocates a long-term investing strategy, shrugs off those concerns, noting that its performance has held up over time. During the past 10 years, its funds have on average beat the S&P and bested two-thirds of its peers.

The recent slump is due partly to the firm’s heavy concentration of large-cap stocks, which have been outpaced by smaller-cap equities.

Clients began pulling money in 2008 and the outflows have grown each successive year. In 2011, Capital Group faced nearly $82 billion in redemptions, by far the most of any fund firm in the country.

Because of its large size, outflows will naturally be larger. But as a percentage of assets, its redemptions are not out of line with industry averages, the company noted. Still, the decline has been stark: Managed assets have fallen by nearly one-third during the past five years to $1.1 trillion.

Even starker is the decline in the institutional investment unit, Capital Guardian Trust Co., which has a concentration in non-U.S. equities. Its assets have dwindled from $160 billion in 2006 to just $40.1 billion as of Dec. 31 amid outflows and performance declines. In response, Capital Guardian has fired underperforming managers and reorganized the division.

Despite a tentative rebound in the equities markets, financial advisers have continued to lose faith in the firm. A recent survey by industry research firms Kasina LLC and Horsesmouth LLC found that just 45 percent of advisers would recommend Capital Group, down from 58 percent a year ago.

Eileen Freiburger, a financial adviser in Manhattan Beach, said she doesn’t endorse American Funds as much these days because its limited offerings make it difficult to assemble a diversified portfolio.

“They’re certainly a very, very good fund family, (but) if an investor is not already in it, it’s not something I’m recommending,” said Freiburger, the president of ESF Financial Planning Group.

Capital Group is sticking primarily to its traditional niche of actively managed large-cap stock portfolios; some of its large holdings include Microsoft Corp., Home Depot Inc. and Volkswagen AG. Unlike some of the firm’s competitors, the American Funds family doesn’t offer exchange-traded funds, funds that short stocks or gold funds.

For Emerson Fersch, a financial adviser in Long Beach who has been investing in American Funds for 17 years, the firm’s commitment to consistency – whether in their product offerings or interaction with investors – has become a symbol of its unwillingness to accommodate clients in a changing investment environment.

“The selling point for American Funds is how they don’t deviate from their plan,” said Fersch, who runs Capital Investment Advisers. “That became part of their undoing.”

He has pulled $12 million from Capital Group since 2008.

Heavy competition

A key problem for Capital Group is recent equity market volatility that has driven many investors to bonds.

Capital Group has only limited bond offerings and has been losing ground to fixed-income firms such as Pimco, which added $28 billion last year.

And Capital Group is facing arguably greater competition from firms such as Vanguard and Dimensional Fund Advisors that specialize in index funds, designed to track the performance of market indexes, such as the S&P. Less expensive than actively managed funds, passively managed index funds were created with the belief that stock pickers cannot consistently beat the market, a position that has been bolstered by results in recent years.

“Active managers are having a hard time beating their benchmarks,” said Katherine Krantz, managing director of Miracle Mile Advisors Inc., a Beverly Hills investment firm specializing in passively managed funds. “People aren’t seeing performance and they’re sick of paying the fees.”

Capital Group has prided itself on offering lower fees than most active managers, but the charges still cannot compete with low-cost index funds. In the American Funds family, fees range from 0.55 percent of invested assets to slightly more than 1 percent; equity index funds often charge about 0.3 percent or less, according to Denver-based research firm Lipper.

Vanguard, a pioneer of index funds, recently passed Capital Group to become the country’s largest mutual fund manager. Both Dimensional, which is headquartered in Austin, Texas, and has a large presence in Santa Monica, and Vanguard pulled in more than $15 billion of investors’ money last year.

Weston Wellington, vice president of investment strategies for Dimensional, said he does not expect the trend toward passive management to fade away.

“Ever since index funds were introduced and dismissed as a stupid idea … they have slowly chiseled away in terms of market share at the actively managed fund industry and continue to do so,” he said. “It’s not as if active management has disappeared, but they obviously have lost significant market share.”

Capital Group recognizes that index funds are in vogue, but the firm was founded on the belief that active managers can beat the market over the long run.

“We try to keep an open mind and look at all of these ideas and ask: Does this make sense for an individual shareholder, can we do this well and does it fit with the way we manage money? We try to judge that against some very strong, basic beliefs,” Freadhoff said. “We believe in active management. This is a particularly difficult period for active managers, but we’ve been through difficult periods before.”

Making changes

The firm, however, is bolstering its product line in response to the growing sentiment among investment professionals that Capital Group’s current offerings are insufficient.

The eight new funds will have a fund-of-funds structure, meaning they will invest in several of Capital Group’s existing portfolios. The idea, Freadhoff said, is to allow investors to diversify their holdings through a single fund.

The new funds will effectively lower costs for some investors since they will provide entrees into multiple funds for a single management fee.

“We are responding to requests from advisers who asked us to make it easier for them to provide a group of funds in a single portfolio,” Freadhoff said.

Citing a regulatory quiet period, he would not provide additional details.

Greenwald, the mutual fund consultant, said the new offerings suggest that the company, which is known for doing things its own way, may recognize the need to better accommodate investors.

“They have been very, very reluctant to start new products. They felt that their basic products served the needs of the marketplace, and now they’re obviously re-examining that,” he said. “It represents that they’re becoming more flexible perhaps than they have been in the past.”

Capital Group is also opening up its lines of communication with a broad social media push. The firm recently launched a Facebook page, is creating YouTube videos, and expects to join LinkedIn and Twitter soon.

Social media has become an essential tool for many investment professionals, the firm noted. The intent is to share information on its funds and other educational materials with financial advisers and investors.

Greenwald said the move represents a big step for Capital Group, given its history of keeping a very low profile.

But the firm has lost significant ground to competitors lately and he questioned whether Capital Group will have to make more dramatic changes. The firm will survive, he said, but its status has changed significantly.

“They’re a solid organization and I suspect this too shall pass,” Greenwald said. “But they’ve lost momentum at a time when it will be very difficult to reach the heights they had in the past.”

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