Buy the Unloved, 2010 Style

If chasing hot performers hasn't gotten you very far, consider doing the opposite.

Categories with the greatest inflows tend to underperform and those with the greatest outflows tend to outperform. Net flows tend to be driven by past returns, so, in effect, they are telling you what areas have gotten relatively overpriced and underpriced. If the market and fund investors were perfectly efficient and logical, flows and prices would only adjust so that everything had a similar potential risk/reward profile.

However, markets and fund investors generally overdo things in both directions, as the markets of the past two years illustrate vividly.

Since 1994, Morningstar has tracked a strategy named "buy the unloved," which suggests investing in funds from the three most heavily redeemed equity categories from the past 12 months. In addition, it suggests trimming back your positions in the three loved--meaning the most purchased--equity categories.

If you think about it, the logic is somewhat similar to rebalancing. When you rebalance, you are generally selling what's expensive and buying what's cheap because the expensive holdings in your portfolio are those that have rallied the most. Fund flows tend to follow performance, so this strategy reflects a similar approach, only with an emphasis on the extremes, where the most money moved in or out.

To implement the strategy, you buy funds from the three most unloved categories and do so again the next year and the year after that. In the following year after accumulating three batches of unloved categories, you roll money from the first batch into a new batch so that your holding period is three years.

From 1994 through 2009, the buy-the-unloved strategy produced an annualized 8.1% return, compared with 4.77% for the loved, 6.24% for the S&P 500, 6.96% for the Wilshire 5000, and 5.36% for the MSCI World. This assumes you invest in the unloved categories for three years running and then roll over the oldest group into the new unloved group starting in year four.

The strategy also produced strong results if you run it on a five-year rotation. In that version, the unloved produced an 8.08% annualized return, compared with 4.25% for the loved, 5.17% for the S&P 500, 5.76% for the Wilshire 5000, and 4.55% for the MSCI World.

Based on the 12-month flows through the end of January, the unloved categories to buy now are large-cap growth, large-cap value, and world stock. The loved categories are diversified emerging markets, foreign large blend, and Pacific Asia ex-Japan.

Favorites for Playing the Unloved

Among large-growth funds,  Primecap Odyssey Growth (POGRX) is one of the best fundamentals-driven growth funds around. As you can see from the record of closed  Vanguard Primecap (VPMCX), the managers have built an outstanding track record by focusing on what a business is worth rather than growth rates or quarterly expectations. One catch is that you have to either invest directly or pay a fee to buy it through Vanguard.

For large-cap value, the most contrarian plays are dividend-focused funds, which have been unpopular because of their link to banking and the economy. Thus, I'd take a look at  T. Rowe Price Equity Income (PRFDX) and  American Funds Washington Mutual (AWSHX); the latter has seen more outflows than any other fund in 2009.

In world stock,  Dodge & Cox Global Stock (DODWX) is a nice choice. It's a low-cost combination of the strategies of  Dodge & Cox Stock (DODGX) and  Dodge & Cox International Stock (DODFX). It does have different managers and a different portfolio than you'd get from simply gluing the other two together but the end result will likely be fairly close. The strategy is a straightforward take on value but Dodge's depth of managers and analysts enables it to shine in the long run.

Drew Brees Wins the Vote

Last week, I asked: Who's having the best year so far? Here's how you voted.

34% - Bruce Berkowitz

43% - Drew Brees

3% - Daryl Morey (Houston Rockets GM)

20% - Lindsey Vonn

This is an updated edition of an article that first ran in the January issue of Morningstar FundInvestor.

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