Here’s a question I saw on the recently formed White Coat Investors Facebook group:
Curious what everyone’s opinion regarding American Funds vs Vanguard. My Spouse already has an American Funds account, which was set up years ago. I have Vanguard. My advisor is recommending I transfer my Vanguard traditional IRAs and old 403(b) into American Funds as well. I’ve always read fees are the enemy but the prospectus and prior performance of American Funds sure look enticing. Thoughts?
American Funds run several large actively-managed mutual funds. The historical performance of their funds have generally exceeded that of the general market, but they also charge higher fees. Unlike Vanguard, many investment advisors are offered financial incentives to sell American Funds, so this might explain why this financial advisor is pushing the reader to make the switch.
While I know that most of my readership understands that index investing is superior to active investing, not everyone is convinced, and there was a lively debate on the merits of active investing in that Facebook thread.
When new investors ask important questions such as whether to invest in active vs. passive mutual funds, the personal finance community can become a bit of an echo chamber where people just vote for #TeamIndexing without fully explaining its benefits to these new investors.
It’s worthwhile every once in a while to repeat the benefits of index investing. Let’s do it in the context of this Facebook question: should an investor put their money in actively-managed American Funds or passively-managed Vanguard funds?
Fees are lower with index investing
Both sides of the active vs. passive investing debate can agree on one thing: it is cheaper to invest in index funds than in actively-managed funds. Fund managers are smart people with fancy advanced degrees such as an MBA or Ph.D. Just as physicians want to be compensated well for their years of medical training, fund managers want to be compensated for the years they spent learning about finance in business school or graduate school.
In addition, fund managers need research staff (who often also have MBAs) to help analyze possible investments, and they often will visit company executives to gain insight on an investment’s future prospects.
All of this costs money, and actively-managed funds charge their investors for this effort. Running an index fund, on the other hand, is very inexpensive, because there is no money spent on expensive fund managers or market research. The cost to run an index fund comes mostly from the transactional costs of buying and selling shares in the underlying index.
As an example, The Growth Fund of America (GFFFX) F-2 shares (meaning you also have to pay an asset under management fee to an advisor to access this share class) has an expense ratio of 0.43%, while Vanguard (VFIAX) has an expense ratio of 0.04%.
Index Funds Are More Tax-Efficient
Even if an actively-managed fund were to beat their underlying index net of fees, they would still have to overcome their relative tax-inefficiency compared to index funds. Actively-managed mutual funds buy and sell stocks far more frequently than a passive index approach. For example, The Growth Fund of America has a turnover ratio of 25%. This is compared to Vanguard’s Total Stock Market Index Fund (VTSAX), which has a turnover ratio of 3%.
Every time a mutual fund buys and sell stocks, they generate capital gains, which must be passed on to the investor. Therefore, in a taxable account, the after-tax return of an actively-managed fund would be generally lower than that of a passive index fund if they had the same after-fees return.
Of note, there are no taxes on capital gains distributions within retirement accounts such as an IRA or 403(b), so this point does not directly apply to the Facebook reader’s question.
If you pick active investing, why American Funds?
Index investing is a commoditized business – you can’t really go wrong between Vanguard, Fidelity, or Schwab, and in most cases, you are choosing firms based on either intangibles or cost.
On the other hand, if you want to invest in an actively-managed mutual fund, why must it be American Funds?
Most actively-managed funds fail to beat the market
Not every actively-managed fund is a winner. In fact, after fees, most are losers. By definition, relative to the index fund return, active fund management is essentially a zero-sum game. And because of fees, this means that the vast majority of actively-managed mutual funds underperform the market.
According to a report from Standard & Poors, over a 15-year period from 2002-2016, 92% of large-cap, 95% of mid-cap, and 93% of small-cap funds underperformed their index benchmark.
Survivorship Bias in Mutual Funds
American Funds markets their long track record of overperformance – after all, they’ve been investing since the 1930s. So does American Funds have a special advantage that other mutual fund companies don’t have? Their advantage is certainly not related to having a star fund manager, because the people who worked for American Funds in the 1940s and 1950s aren’t still working for the fund today.
One possible explanation is survivorship bias. When American Funds quotes that it has beaten the market in 95% of rolling 30-year periods from 1934-2016, that’s potentially because it is only looking at funds that are still alive today. It is possible that American Funds that have underperformed the market in the last 80 years were closed, and the performances of these funds were not included in their count.
Even if American Funds has never closed a mutual fund for poor performance since the company was founded in the 1930s, it is possible that there is a survivorship bias among fund families. There are hundreds of different fund companies. Just as there is luck between individual fund managers, there also can be luck between fund companies. For every fund family that has beaten the market in 95% of rolling 30-year periods, there is probably a fund company (or 10) that underperformed the index by the same metric. However, those fund companies probably don’t exist anymore to tell you about their underperformance.
What is so special about American Funds that it will outperform other mutual funds?
Even if you believe that investing in an actively-managed mutual fund will outperform an index fund, how do you know it will be an American Fund which will do so? Why not a Fidelity actively-managed mutual fund? Even Vanguard offers actively-managed mutual funds. What is it about American Funds that will make it outperform other mutual fund families?
I don’t see an identifiable edge that American Funds possesses that other fund companies could not also have. When it comes to having an edge on the market, my suspicion is that hedge funds would be more likely to have an edge over mutual funds. They charge much higher fees, so the most “talented” stock pickers would flock to work for those types of funds rather than a mutual fund.
Another issue is the size of the major American Funds. Their largest funds manage tens of billions of dollars, and their largest fund, The Growth Fund of America, manages a whopping $187 billion dollars. Even if you had a good investment idea (or 2), it is hard to generate alpha (market-beating return independent of volatility) on a hundred-billion dollar portfolio.
Some fund companies choose to close very large funds to new money for this very reason, but American Funds deliberately chooses not to. Instead, they merely hire new managers to manage the new money that comes in.
Conclusion
The debate between investing with actively-managed American Funds and passive Vanguard index fund continues to rage on, even if it might feel like a settled issue to most investors who read personal finance blogs. It is important to periodically be reminded of the benefits of index fund investing, so that you can stick with your index fund investing plan for the long-term whenever a financial advisor, fund company, or fellow investor tells you otherwise.
What do you think? Have you invested with American Funds in the past?
I currently own 3 different American Funds. These were purchased starting in the late 80s. I have large gains and no pleasant way out. I would not buy them now. Investing does change. All these index funds did not exist back when I started investing. Regular DCA produced a big position over time. Oh well, first world problem.
Pretty sure index funds were around in the 1980’s
When I finally started investing in an ira (last couple of years of residency and fellowship) my cpa put me in touch with a financial advisor who promptly put me in American funds before I knew better. I carried those funds for almost a decade before I came across index fund concept which I thought was a more logical approach. Even though I paid the front load already on the funds and had a sunk cost I decided to switch then and there to vanguard index funds and haven’t looked back
indexing all the way. I drank the cool-aid and it was good.
TPP
I went with American Funds a few years ago without knowing any better. Now that I’m researching and learning more about investing, I wish I hadn’t. I paid the front load fees as well. I’m trying to decide if it’s better to leave it where it is or move over to index funds??
Folks! Fee’s matter. Results matter more! Society has said fee’s are the enemy. The enemy is followership and ignorance. You’re not brilliant for choosing free. (Schwab offers free indexing). Investing is taking on risk. If it’s free and easy, and feels good. It’s probably not right. 500 US companies, is also not a portfolio. I love the first brainchild… Owned Amfunds since the 80’s. Large gains. No way out. What the hell else did you want? Large losses, easy out? Perfect! Own the SP500 in 2007. 58% loss. Easy out! No fee’s. Brilliant! Wake up, realize you’re not brain surgeons. Do it yourself if you wish, but at minimum, know what you don’t know. Results are all that matter. What would you earn at the end of the time period, after fee’s, regardless of cost. Last- Investment fees are for more than the investment in certain situations. If you want an advisor. Do the research and some advisors get paid on the investments. It’s not a dirty sin. Research how they get paid, use your brain to make an educated decision if you trust the person. If not, move on. No amount of regulation or noload fund investing will protect you. Vanguard has great funds. American has many that outperform at higher cost, and come with an advisor. So do many other fund company’s. Reality: 90% of funds don’t outperform indexing. 10% do. Work in the list of 1500 funds not the 15,000 that are subpar.
Articles like this are completely ridiculous, but I wouldn’t expect any less considering it is written by a non-financial expert who works as a physician. For anyone who cares to actually look at the data on American Funds, here it is. You will see their funds have beat the index after fees in a majority of rolling 5,10, and 20 year periods. Just for disclosure, I am not a financial advisor, and have never been one, and I do not work for American Funds and never have. https://www.capitalgroup.com/advisor/pdf/shareholder/MFGEBR-097-619801.pdf
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