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How to Buy the Unloved 2013

Our studies show it pays to hold funds in unpopular categories.

Katie Rushkewicz Reichart, CFA, 03/01/2013

Each year, we look at the equity categories that have experienced the greatest outflows and inflows to gauge which areas of the market are unloved or overheated. The idea is to use fund flows as a contrarian indicator, buying into the categories that investors are fleeing while trimming exposure to those that are popular. We have tracked this strategy since the early 1990s, and research indicates that holding funds in the unpopular categories for at least three to five years is an effective approach that yields strong results.

1 The Most Loved
The most popular equity categories in 2012 were diversified emerging markets (inflows of $23.4 billion), foreign large value (inflows of $4.6 billion), and real estate (inflows of $3.8 billion). Those looking across asset classes might want to be cautious about sending new money to intermediate-term bond (inflows of $112.3 billion), short-term bond (inflows of $37.6 billion), and high-yield bond (inflows of $23.4 billion), particularly as interest rates have nowhere to go but up.

2 The Most Unloved
The most unloved equity categories are also the most unpopular overall: large growth (outflows of $39.5 billion), large value (outflows of $15.9 billion), and large blend (outflows of $14.8 billion). These categories have seen outflows despite posting double-digit gains for the year to date through mid-December. The money leaving these categories reflects a broader trend of investors fleeing equity funds while piling into fixed-income offerings and passive exchange-traded funds. Some of these categories have endured outflows for a while. Large growth has had annual net outflows since 2004, large value since 2007, and large blend since 2010.

3 Funds in the Unloved
Here are some fund picks in unloved categories that could serve as good long-term holdings. Harbor Capital Appreciation HACAX is a reliable large-growth option. Longtime manager Sig Segalas and team have produced strong long-term results by focusing on steady blue chips and more-aggressive names whose sales growth is increasing faster than that of the S&P 500. Over time, it has held up well in market downturns.

Investors looking for higher growth might instead opt for Primecap Odyssey Growth POGRX or Primecap Odyssey Stock POSKX. These Gold-rated funds often invest in small- and mid-cap stocks and make sector bets, so they can look out of sync from peers at times, but both have stellar long-term records.

Vanguard Growth Index VIGAX is a low-cost, passive way to gain access to large-growth stocks. A recent change in index (from the MSCI US Prime Market Growth Index to the CRSP US Large Cap Growth Index) means there could even be more cost savings for investors down the road.

On the large-value side, Sound Shore SSHFX is a good choice. Despite a middling three-year performance, it has generated an enviable record under its management team, which has been in place for more than 25 years. Dodge & Cox Stock DODGX is also proving it’s worth sticking with; after its financial stake hurt results in 2011, it was back in top form in 2012.

Large-blend investors might opt for Gold-rated FMI Large Cap FMIHX, which has comfortably beaten the S&P 500 Index and nearly all peers during the past decade. The portfolio has less than 30 stocks, but a focus on durable, high-quality businesses has kept volatility in check during down markets. Patrick English, who has been with employee-owned FMI since 1986, leads a team of comanagers who also serve as analysts. This collaborative structure has helped retain talent.

Vanguard Dividend Growth VDIGX is another standout large-blend option. It looked sluggish in 2012’s market, which was no surprise. Instead, it leads the way in more risk-averse environments, such as 2011’s. Its longterm prospects remain good, with a proven process and manager. The fund is one of the cheapest actively managed dividendfocused funds around.

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Katie Rushkewicz Reichart is a senior mutual fund analyst with Morningstar.

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