Should You Buy American Funds' Laggards?

To identify these laggards, I screened all American Funds on relative performance for the three- and five-year periods ended Sept. 30, 2007. (Shorter-term performance measures aren't very useful.) I focused on funds that have lagged their typical category rival over both periods. Not surprisingly very few of American's funds passed that screen; even those with out-of-favor approaches often beat their peers through a combination of good security selection and low costs. I did, however, find four funds that fit the bill: American Mutual (NASDAQ: - ), High-Income Municipal Bond (NASDAQ: - ), New World (NASDAQ: - ), and Washington Mutual Investors (NASDAQ: - ). I'll tackle these one by one.

American Funds American Mutual
Category: Large Value
Three-Year Return (% Rank in Category): 12.14% (74)
Five-Year Return (% Rank in Category): 14.10% (86)
American's large-value funds don't delve as deeply into troubled, economically sensitive fare as many of their category rivals, and that cautious tack has held the three funds--this one, Investment Company of America (NASDAQ: - ), and Washington Mutual--back in the post-bear market rally. This particular fund favors companies that pay substantial, predictable dividends and have strong balance sheets; such firms haven't benefited much from the availability of easy credit in recent years. Also, the fund's managers are quite willing to hold cash when they can't find compelling ideas--its cash stake was recently 13%--which has weighed on returns in equities' rally. However, the fund's prudence served shareholders quite well in the bear market (it owns a fine long-term record), and I would expect the fund to hold up relatively well in most troubled environments. Indeed, when the equity markets were roiled this past summer by mortgage-lending issues, the fund performed well--though it's now only slightly above-average for the year to date through Oct. 17, 2007, as stocks have bounced back. I think this fund is a fine choice, particularly for risk-averse investors.

American Funds High-Income Municipal Bond
Category: High Yield Muni
Three-Year Return (% Rank in Category): 4.34% (73)
Five-Year Return (% Rank in Category): 4.6% (63)
This fund lands in the laggards camp for the simple reason that it doesn't take on as much credit risk as its typical rival. That was a handicap in a nearly five-year rally by lower-quality bonds (both taxable and municipal) that ended in early 2007. However, the fund's typically defensive posture provides downside protection when trouble hits: Witness its fine showing in 1999, when high-yield muni funds posted losses. Similarly, the fund has weathered investors' recent "flight to quality" amid the market's turmoil quite well. But this fund does more than just play defense. The experienced team of managers and analysts who run it have generated fine long-term results through savvy issue selection. (It lands just outside the category's top quartile over 10 years.) I think investors have every reason to hang on here.

American Funds New World
Category: Diversified Emerging Markets
Three-Year Return (% Rank in Category): 31.68% (90)
Five-Year Return (% Rank in Category): 30.25% (89)
Here's another fund with a different mandate than many of its category rivals. New World invests in emerging-markets equities, along with its peers. However, it also owns companies domiciled in developed markets that do business in emerging economies, as well as emerging-markets debt, and will hold a substantial cash stake, as well. The fund's relatively conservative positioning has held it back during emerging-markets stocks' spectacular rally. It tends to look better when those stocks hit a rough patch, and I like its wide-ranging mandate--particularly because American has plenty of investment staff to support its broadly diversified portfolio. That said, it's important to note that even this relatively tame fund has posted unsustainably high absolute returns in recent years, and it's certainly not immune to sharp losses. (It declined 21% in 2000, for example.) I think it's well worth holding, but many shareholders may need to rebalance back to their target allocations for the fund after its recent run. And if I didn't own it, I wouldn't buy it right now.

American Funds Washington Mutual
Category: Large Value
Three-Year Return (% Rank in Category): 12.56% (68)
Five-Year Return (% Rank in Category): 14.9% (74)
This large-value offering has a set of strict criteria that ensure its holdings are of relatively high quality. For example, a company must have paid a dividend in nine of the last 10 years in order to be included in the portfolio (four of the last five for financial-services firms). So it tends to hold larger, more established firms that crank out steady streams of cash. (Its average market capitalization is roughly double the group norm.) That tack worked against the fund from 2003-06 as dicier firms, and small caps in particular, thrived. But it's beaten three quarters of its rivals in 2007, and I think its emphasis on mega-caps should give it a leg up when the broader economy cools. Its low 0.57% expense ratio helps more of the portfolio's yield flow through to shareholders, too. This is American's strongest option to fill the large-value slot in a portfolio.