Buy the Unloved 2011

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Each year we let you know where the Buy the Unloved strategy suggests you should invest. The idea is to buy funds from the three least-popular equity categories and sell those from the three most-popular. Popularity is determined by fund flows for the prior calendar year.

Holding the unloved funds for three to five years and selling or trimming the loved for that same period have yielded strong returns over the years. However, the results are lumpy. They work beautifully when there's a dramatic pivot year like 2008 or 2009, but they lag in years when category performance is more consistent. This indicates a couple of things. First, you need to stick with the strategy for a while. Second, this is something to do at the margins of your portfolio rather than at the center.

So, how did the strategy perform? From the beginning of 1994 to the end of 2010 , the unloved earned 308% cumulatively or 9% annualized. That's far better than the loved, which earned 157% cumulatively or 6.1% annualized. The MSCI World Index returned 4.6% annualized, and the S&P 500 returned 8% annualized.

This year's unloved categories are large growth (outflows of $45 billion), large blend (outflows of $17 billion), and large value (outflows of $4.5 billion). The loved are diversified emerging markets (inflows of $28 billion), foreign large blend (inflows of $18 billion), and commodities broad basket (inflows of $4.2 billion). Below I have selected some of the best actively managed and passively managed funds for playing the three unloved categories. Among active options, because the strategy is really a bet on an undervalued asset class, I opted for funds that are fairly straightforward and not among the quirkiest of options.

In large growth, I suggest Harbor Capital Appreciation HACAX or T. Rowe Price New America Growth PRWAX as solid, low-cost actively managed expressions of large growth. Should large growth finally enjoy a strong run, these funds should be in clover. If you want an index fund, consider Vanguard Growth Index Admiral VIGAX, which has an expense ratio of 0.14%.

Among large-blend funds, I like Vanguard Dividend Growth VDIGX, which is run by Donald Kilbride of Wellington. I'm also a fan of Longleaf Partner LLPFX and American Funds Fundamental Investors ANCFX. On the passive side, Vanguard Total Stock Market Index VTSAX is the way to go.

In large value, Dodge & Cox Stock DODGX and T. Rowe Price Equity Income PRFDX are outstanding, dependable, low-cost actively managed funds. The former is a little more wide ranging, while the latter is anchored to big dividend-paying stocks. Vanguard Value Index VVIAX, which has a low 0.14% expense ratio, is among the cheapest ways to bet on large value.

Russel Kinnel is director of mutual fund research with Morningstar.