- Global equities continued their rebound, led by technology-related companies.
- Our growth funds continue to fare better against indexes than our growth-and-income funds.
- In a narrow market, funds with an emphasis on growth and income have historically rewarded investors.
Two steps forward, one step back
Global equities posted a second consecutive quarter of strong gains following a pandemic-induced selloff earlier in the year. However, fears of additional COVID-19 outbreaks in the fall sent markets lower in September. Both developed and emerging markets rose, supported by massive government stimulus measures and investor optimism for a global economic recovery.
U.S. equities produced the strongest returns across the major regions, with Standard and Poor’s 500 Index (S&P 500) in positive territory (up 5.6% year to date) after entering and exiting its fastest ever bear market and correction earlier in the year. On a one-year basis, the major U.S., international, emerging markets, and global indexes had all turned positive — a fact that would have seemed outrageous in March.
Consumer-oriented technology companies, especially those based in the U.S., generated some of the largest gains relative to their size in global indexes, lifted by a surge in global online and e-commerce activity. The information technology sector rally pushed some broad-based indexes to new all-time highs. Certain industrials and materials stocks also rallied amid a recovery in global demand, while most energy stocks fell sharply. The energy sector has fallen 42.4% year to date in the MSCI All Country World Index (ACWI) amid a true crisis of both supply and demand.
The U.S. Federal Reserve took no action on interest rates during the quarter, and the central bank revised its inflation stance to allow for longer periods of price increases before considering any rate increases. The global financials sector continued to trail the broad market during the quarter and remains down 22.4% year to date, second only to energy in the MSCI ACWI.
This year has been an incredibly challenging time for investors seeking income from dividend-paying companies. Unlike many past market downturns, large swaths of dividend payers have broadly lagged the market. In the MSCI ACWI, the year-to-date total return difference between the highest and lowest yielding quintile was more than 50% (-23.4% versus +27.4%).
Against this backdrop, some of our equity funds strive by objective to pay income to shareholders. Around the globe, this has made it difficult for some of those funds to outpace market-cap weighted benchmarks in the near to medium term. In fact, on a year-to-date basis, this distinction of whether or not a fund aims to generate income has correlated with its success in outpacing broad indexes. Regardless of primary geographical focus, all of our growth funds have outpaced their primary benchmarks year to date, while conversely, all our growth-and-income funds have trailed them.
Growth funds fare better than growth-and-income funds
Our U.S.-focused growth funds, The Growth Fund of America® (GFA) and AMCAP Fund®, outpaced the S&P 500 year to date. GFA outpaced the market in the third quarter as well, due in part to a larger position in consumer discretionary companies offering products that meet COVID-induced consumer demands, such as digital or contactless service. However, AMCAP trailed the S&P 500 in the third quarter due in part to having less exposure to cyclical sectors and industries than the index. Companies in these sectors benefited from stronger demand for cars and homes, despite weak overall consumer spending. The fund also held fewer technology holdings than the index, which held back returns, as did its investments in the biotechnology industry and energy sector.
All of our U.S.-focused funds that include income as an objective trailed the S&P 500 in both the third quarter and year to date in 2020. These growth-and-income funds included American Mutual Fund®, Fundamental Investors®, The Investment Company of America® and Washington Mutual Investors FundSM (WMIF). The reasons of course vary by fund, but it’s hard to ignore the fact that the income objective has been out of favor in this market environment. In the case of WMIF, the third-quarter drag on results came from such factors as not holding a meaningful amount of some of the top-returning technology companies, as well as stock selection in the health care sector.
Outside of the U.S., the same trends hold true — each growth fund has outpaced its primary benchmark while each growth-and-income fund has trailed it. EuroPacific Growth Fund® has demonstrated strong results against its benchmark (MSCI ACWI ex USA) in both the third quarter, outpacing it by more than 340 basis points, and year to date, outpacing it by more than 980 basis points. In the third quarter, stock selection was the key driver, with positive contributions coming broadly across nearly every region and sector within the index. Companies within the energy and communication services sectors were the largest contributors. International Growth and Income FundSM, however, lagged in the quarter because of holding fewer consumer discretionary companies and certain European communications companies that have previously provided attractive dividends.
Among our global funds, New Perspective Fund® (NPF) delivered strong excess returns in the third quarter, outpacing the index by more than 450 basis points. Year to date, NPF is 12.8% ahead of the MSCI ACWI. In the third quarter, the driver for excess returns was stock selection in the consumer discretionary sector; but most sectors provided positive stock selection, with certain health care companies playing an important role. By contrast, Capital World Growth and Income Fund® lagged in the third quarter in part because of its holdings in certain dividend-paying consumer staples and a lack of ownership in certain information technology companies.
Finally, SMALLCAP World Fund® stands tall, with the fund’s results having outpaced the index on all common time frames. The magnitude is extreme in some cases, such as the one-year returns, where the fund is 22.3% ahead of the MSCI All Country World Small Cap Index. The success in the third quarter was owed largely to holding fewer financials and real estate firms and more consumer discretionary companies than the index.
Implications of a narrow market for diversified investors
A notable trend in the ongoing market recovery is the narrowness of equity index returns, with some of the largest U.S.-based technology and consumer-oriented companies providing major contributions to various index returns. This trend has meant that asset allocation has been a dominant driver of investors’ returns in recent years — the implications of the largest companies doing so well are dramatic on the relative outcomes of individual portfolios.
For example, the six FAANGM stocks (Facebook, Apple, Amazon, Netflix, Google and Microsoft) have played an outsized role on the S&P 500 Index:
- They account for the five largest companies on the index.
- They represent more than 23% of the index’s market weight.
- They have accounted for 48% of the index’s gains in the last three years.
These all pose challenges for active managers, as keeping up has necessitated an embrace of market leadership that we believe may run counter to prudent portfolio management. Furthermore, some structural impediments exist. For example, at Capital Group our mutual funds are generally well diversified due to a combination of The Capital SystemSM (where multiple investment professionals independently manage portions of a strategy’s assets), internal strategy-specific guidelines and SEC requirements that limit exposure to individual companies, industries and regions.
While it paid to take concentrated risk in the U.S. over the last decade, the million-dollar question is, “Where will the next decade take us?” We don’t have a house view on that question. Some of our investors have drawn parallels to 1999, another point in time when growth stocks outpaced value stocks by such a wide margin. Others have countered that many of the largest companies today have steady earnings and are truly growing faster than the broad market. Additionally, the shuddered economy is not as strong as it was in 1999 and rates have been falling rather than rising.
We do think it makes good sense for investors to maintain both diversification and flexibility in portfolios, and the dot-com bubble serves as a good reminder. For example, The Investment Company of America (ICA), which seeks to provide capital appreciation and income, has trailed the S&P 500 over the last 10 years. Over the last 50 years, the only other time where the fund’s 10-year return trailed the S&P 500 for more than several years was in the late 1990s. At that point in time, however, the results drag was even more pronounced, as the fund had trailed over the last 20 years for approximately two years.
The dot-com bubble eventually burst, and ICA provided downside resilience that led to meaningful excess returns of rolling 10-year results for the periods that lasted through March 2012. Over the entire 50-year stretch, the fund outpaced the S&P 500 in 70% of all available 10-year periods. The result has been 27% more wealth created for investors, and much of that value was created via downside resilience. A similar explanation could be provided for our other U.S.-oriented growth-and-income funds (American Mutual Fund, Fundamental Investors and WMIF), all of which outpaced the S&P 500 a majority of the time over rolling 10-year periods during this same time frame.*
Will calmer waters prevail in turbulent times?
For investors, making sense of the recent turbulent period feels daunting. Our portfolio managers and analysts can relate, and there remain healthy discussion and debate within our investment groups on many issues, some of which we have already discussed:
- How to prudently select dividend-payers for the downside resilience that they have historically provided.
- The implications of the equity market’s narrowness for diversified investors.
- How trends that have been accelerated by the pandemic have led to rapid redefining of many business models, leaving practically all industries up for grabs.
On this last point, the acceleration of companies redefining their industries’ business models has been a notable feature of returns across global equity markets this year. This is evident not only in platform companies but also in medical technology, biotechnology and even the automation of the mining industry. Mining companies are remotely operating autonomous machines from a central control room, and then collecting performance data to optimize future use of those machines. The companies that are able to create the most efficient processes through technology — whether they're the largest incumbents or not — stand to grow profit margins and take market share.
We believe that trying to link global macroeconomic events to recent market outcomes misses the bigger picture — that many industries today seem up for grabs, from biotechnology to mining, leading to plenty of attractive investment opportunities around the world for active managers.
To say the 2020 investment environment has been challenging for active equity investors would be an understatement, but we remain resolute in our long-term focus, confident that some of the strongest businesses of tomorrow can be found and purchased at attractive prices today. In our view, the search for calmer waters in turbulent times must be done on an industry-by-industry and, more importantly, company-by-company level.
*Based on monthly rolling periods between 12/31/66 and 9/30/20 for American Mutual Fund (62%) and Washington Mutual Investors Fund (68%). Fundamental Investors (80%) uses its inception date of 7/31/78 for the start date.