Turning a Tanker Truck on a Dime

My employer became quite excited about rolling over our SIMPLE IRA plan to American Funds a couple of weeks ago (he is very excitable). I wasn't terribly impressed by the rep's sales patter (the representative was billed as a "Financial Advisor" on his business card, but he didn't have any designations on it, like CFA or CFP), so I did my own research. As it turns out, it was undeniably a great fund family to get into some years back. Now it is a matter of some debate if it is wise to invest in these funds.

I did the best apples-to-apples comparison I could and stacked up their growth fund against the one I already own. One of the criticisms of American Funds that has been consistent in the financial press is their bloat. This became readily apparent looking at the numbers. You may be familiar with the idea of inventory turnover, and holdings turnover is similar in concept (though the analogy quickly falls short, as we'll see). An aggressive fund should see fairly high holdings turnover - stocks are being sold more frequently. I hasten to add that there are legitimate reasons not to do this too much, as buying and selling incurs trading fees, and stocks should be held for an optimal length of time in order to profit from them while avoiding selling them so soon that short-term gains taxes figure in. So there is a good reason to expect some deviation from the norm with respect to holdings turnover. Some deviation . . . the American growth fund I looked at currently turns over at 26%, in contrast to the category average of about 98%. Whoa! That's some stagnant pond water right there.

Let's continue with the bloat issue. This fund has billions of dollars in holdings. American is the biggest fund family now - which is a great selling point to the naive. The savvier among us ask: how in the world can they trade efficiently when they are that large? They run up against the limiting effects of trading volume on any given stock. In other words, a teeny-tiny portfolio like mine is quite liquid, but theirs is not, even though one might normally consider equities to be a liquid asset. It is far easier for me to sell my handful of shares in the space of a few minutes, if not seconds, but a gargantuan fund like one run by American can't move in response to market opportunities because there just aren't that many buyers for them to unload on. As we saw, this is evident in the holdings turnover.

How does one even measure liquidity for a fund versus a corporation when real-world problems like bloat apply? I sure don't know. Most business measures can still be used to analyze a mutual fund, in much the same way a manufacturing corporation, retail store, or bank would be sized up. But weird things seem to happen at many billions of dollars. And although American likes to dismiss the naysayers with their unique "management team" approach, it seems to me that more managers, coupled with the largest fund in existence, only guarantees a regression to the mean - in this case, they will behave no better than an index fund. I find it unlikely that American is, of all known entities in the universe, somehow immune to the law of averages. I guess index performance is okay. But frankly, I see little reason to invest in "professionals" that are bound to deliver no better than average performance.

Call me unpatriotic, but I'm staying out of American.