Buy the Unloved With ETFs

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At Morningstar we've been writing for more than a decade about a strategy that invests in asset classes that investors are selling and sells asset classes that investors are buying. We call this strategy, "Buy the Unloved." Today, exchange-traded funds offer a new way to put this strategy to work.

The Original Strategy
The premise behind buying the unloved is simple: Fund flows chase returns, and the combination of flows and strong past returns are good indicators that an asset class is overvalued. Internet funds in 1999 or real estate funds in 2007 are examples of why you wouldn't want to buy the most popular fund categories. On the flip side, you would have done well buying small-value funds in 2000, when other investors were not.

Here's how the strategy works. Invest in mutual funds from the three equity categories that received the greatest redemptions in the prior year. (Bond funds and asset-allocation funds are excluded.) Then do the same thing the next year and the next year. After three years (or four or five--those time periods work just as well), you start rolling over that original group of funds in the next group of unloved.

Over the years, we've found this contrarian strategy works pretty well. In addition, we've found that applying a similar strategy to funds from the three most popular categories (the loved) each year has done quite poorly. Through October, the top three unloved categories were large growth, large value, and world stock. The most loved were diversified emerging markets, commodities broad basket, and foreign large blend.

The strategy is definitely a niche one. You wouldn't want to touch the core of your portfolio with it.

New Opportunities for "Buy the Unloved"
The growth of ETFs presents some intriguing new opportunities for this strategy. Because the idea is to find undervalued assets rather than great managers, ETFs make a lot of sense as the way to execute the strategy. If it's an asset play, why not invest in the cheapest way to gain exposure? The Buy the Unloved strategy often leads into sector funds or regional funds, yet there are very few open-end index funds covering those areas. Now that ETFs have covered darn near every niche imaginable, we have a new opportunity for a less costly way to buy the unloved.

In addition, because you can short ETFs, it's now possible to Short the Loved, or run a long-short strategy employing both.