Looking for the Unloved in All the Right Places

Morningstar's 401(k) plan has a pretty good reputation. It's a wide-ranging assortment of low-cost funds with solid managers and long-term track records selected by a committee that includes current and former fund researchers from across the company. For that reason the lineup is sometimes a source of ideas for investors. Typically they're interested in which funds the fund analysts are buying.

I decided to turn the tables a bit when I was rebalancing my own account recently. I looked for ideas among members of the Morningstar 401(k) that the outside world has been selling.

There're often great opportunities amid funds suffering outflows--funds with strong long-term advantages that may be temporarily out of favor with the investing public. Such offerings are ideal destinations for cash reaped when you trim your winners. An ongoing Morningstar study has found that buying such unloved funds can be profitable in the long run. That's because the popular funds are often in categories with strong recent trailing returns that have boosted expectations for them to unrealistic levels. Meanwhile, shunned, but still fundamentally sound, offerings usually lurk in areas that have lagged but may be due to lead in the future.

I found a few excellent contrarian candidates by looking at the funds with the biggest outflows in Morningstar's 401(k) plan for the 12 months ended in November. Here they are with a few reasons why they're still worthy investments.

 American Funds Washington Mutual (AWSHX)
This fund owned some of the ugliest of the ugly financials, such as Fannie Mae (FNMA) and  Citigroup (C), and lost a lot of money in absolute terms in 2008. That has given some investors reasons to sell it, but it doesn't mean they're good reasons.

At its worst in the bear market, the fund still beat most of its large-value peers and the Russell 1000 Value Index and maintained a very strong long-term record. Most important, the key characteristics that have helped this fund be a stalwart for decades remain intact: veteran management; disciplined, dividend-focused, low-turnover style; above-average portfolio yield; and low expenses. This fund won't earn you any bragging rights in a raging-bull market, as its weak 2009 category ranking shows, but it can still be a compounding machine for patient investors. I've added money to this fund this year.

 Selected American Shares (SLADX)
If you're a performance-chaser, you've been chasing something else this year. This core fund has gained 12%, but still lags 70% of its peers and the S&P 500 Index. It also took a much harder tumble in 2008 and owned some now infamous financial stocks such as  American International Group (AIG). That's probably driven away some investors, perhaps to their long-term detriment.

Comanagers Chris Davis and Ken Feinberg's record over the trailing 15 years and every rolling 10-year period during their tenure remain excellent. Despite running more than a $50 billion in various funds and accounts, they've still managed to construct a distinctive portfolio of blue-chip, off-the-radar, and contrarian picks. They still own a lot of financials but less than they did before the 2008 crisis, and much of its exposure comes from more diversified holding companies such as  Berkshire Hathaway (BRK.A). Furthermore, Davis and Feinberg are exceptional stewards who invest a lot of money with their shareholders, keep fees low, and stay focused on the long term. I've added money to this fund as well.

 Loomis Sayles Bond (LSBRX)
Here's a fund that's on pace to leave its typical peer and the broad bond market in its dust for the eighth time in nine calendar years, yet it still saw outflows through the end of November. If people are selling this fund because they've gotten hip to its risks and prefer something tamer for the fixed-income portion of their portfolio, that's hard to dispute. The fund often goes where other bond managers fear to tread, which can sting sometimes for short periods, as it did in 2008 when it lost 22%. Still, sagacious manager Dan Fuss has delivered above-average returns over his long career to compensate for the above-average risk. I don't own this fund, but when I need a fixed-income fund, it will be on my short list.

Too Much Love
Funds in the Morningstar plan that have been most popular with the general investing populace were from categories and classes of funds that have been claiming most of the industry's new inflows for most of this year: bond, index, and emerging-markets funds. I would not dump or even avoid  PIMCO Total Return ,  Vanguard Institutional Index (VINIX), or  Oppenheimer Developing Markets (ODMAX) (I only own Institutional Index). But I might adjust my expectations for them.