Meet the No-Star Team

By Daniel Kadlec

Stocks have momentum again, and even though the market cooled a bit last week, some on Wall Street are daring to speak of--gulp--a record-high Dow Jones industrial average, which is just a 9% gain away. Yet even if that pans out, here's one bull-market relic that won't be making a comeback anytime soon: the celebrity mutual-fund manager.

In a typical cycle, now is when stock-picking stars should be preparing to hatch--by jumping into a rising market early with big, brash bets and holding on for a glorious ride. But the tech meltdown of 2000 and a rash of fund scandals changed the game. Star power faded, and up stepped little-known (but not so little) American Funds to rewrite the script for success. American Funds woos investors with a team approach that insulates fund investors from the carnage that a single mistaken ego may unleash. The company is raking in money so fast that it has inspired copycats--just as its funds have grown so large they threaten to become unwieldy.

Nowhere is the team concept more ingrained or successful than at American Funds, whose managers avoid the spotlight like a stock headed for bankruptcy. The company's guiding theme: many heads with varying strategies, each doing his best with his slice of the fund, produce more good ideas and protect the fund from fads. "We've been doing it this way since 1958," says Drew Taylor, vice president of client services. "It's in our DNA."

At most fund companies, the idea of anonymous teams of managers investing funds is viewed as radical. Why? Star managers are money magnets. They get invited on TV; they lift a fund company's profile. Yet starless American Funds, part of Los Angeles--based Capital Group Cos., zoomed past star-centric Fidelity Investments this year in total managed assets through September--$738 billion for American Funds, $716 billion for Fidelity. The company is on track next year to topple kingpin Vanguard ($774 billion), which rode the popularity of index funds to surpass Fidelity in 2003. American Funds has quietly become home to six of the 10 largest stock funds in the U.S.--including the biggest of them all, the $117 billion Growth Fund of America. More than $1 of every $3 plunked into a fund these days goes to American Funds. Vanguard gets about $1 of every $5; Fidelity, just $1 of every $50.

Dreyfus and Morgan Stanley Investment Management are beefing up their analyst ranks in a nod to American Funds' research-driven culture. Putnam Investments now has teams of managers. Even Fidelity has added a second manager to its Blue Chip Value Fund and is hiring 75 analysts who will be aligned with specific funds. "Individual manager accountability is still the Fidelity way," says spokeswoman Anne Crowely. But Philadelphia-based mutual fund consultant Burt Greenwald says the firm is searching for ways to improve returns: "No question, Fidelity is feeling the heat."

The star system won't vanish as long as there are bona fide market beaters like Bill Miller, whose Legg Mason Value Trust is on track to outrun the Standard & Poor's 500 for a 15th consecutive year. "But the industry is waking up to the scale problem that even stars have when a fund grows large," says Christine Benz, author of Morningstar Guide to Mutual Funds.

The scale problem is this: as a stock fund swells with assets, the manager, who usually operates with limits on how much of any one stock can be in the fund, must find ever more winning stocks. And managers of big funds tend to have fewer choices because they focus on shares of big companies. That's because shares of small companies, whose price moves quickly with big trades, tend to quickly get too expensive. And since most funds have restrictions on the percentage of any one company they can own, with a small company even a smart pick has little impact.

As the size problem became evident in the '90s, investors began shifting to index funds, where good ideas don't matter. Index funds buy all stocks in a benchmark like the S&P 500 or any of hundreds of others. They guarantee market-matching returns, are hugely popular and make sense for most people. That makes the heady growth at American Funds all the more noteworthy: the company offers not a single index fund, dismissing them as vehicles for guaranteed mediocrity. "We think you can do better," says Jim Rothenberg, one of nine managers of Growth Fund of America. What's more, sales commissions are the one thing investors loathe, and American Funds dishes out aplenty. Its 29 funds have low expenses but are distributed through brokers who tack on up to 5.75%--anathema to any cost-conscious investor and a sure way to be dissed by the press.

Yet there's more to this unusual fund company than congenital contrarianism. Brokers and clients prize its funds because over long periods they deliver steady gains--lagging in hot markets but shining in tougher times. "I've been putting clients in their funds for 15 years," says Larry Ginsburg, a financial planner in Oakland, Calif. In the downturn of 2001-02, American Funds' Investment Co. of America ($78 billion) fell just 9.7% a year as the market dropped 17.2% a year. Since then, the fund has risen 14% a year, just a shade behind the market's 14.8% annual return. Growth Fund of America, more hard-charging, fell at the same rate as the market during the decline but since then has beat it handily, rising 19% a year. Over the past 15 years, $100 invested in Growth Fund would have grown to $771, vs. $520 in a fund pegged to the S&P 500.

Not everyone is a fan. California sued American Funds, claiming it failed to disclose rewards the company paid brokers for pushing its funds. The suit was dismissed last month. And some are worried that American Funds' biggest funds are at the breaking point that Magellan reached more than a decade ago.

American Funds' Taylor argues that the multiple-manager approach removes size as an issue. Money is parceled out to stock pickers--in the case of Growth Fund, to nine managers and 30 analysts--who invest their portion as they like. When more cash comes in, they add more managers. In theory, the pot never gets too big. Yet this approach has limitations. By design, the fund cannot own more than 10% of any one company. If every manager likes the same stock, one or more must relent--or all get less than they want, which undermines the idea that many stars will outperform one. "We're not having trouble managing the money," says Taylor. But when that day comes, the firm may have to choose a star.