Will These Moat-Heavy Funds Bounce Back in 2011?
Quality large-cap funds have lagged lately but could be poised for a rebound.
Large-cap stock funds didn't get much love from investors in 2010. While the average fund in the three domestic large-cap categories posted double-digit gains for the year, these funds saw big outflows as investors continued a trend that began in 2009, pulling money out of domestic stock funds and putting it into hot areas like emerging markets and commodities. The large-growth category had $45 billion in outflows in 2010, by far the most of any Morningstar category, and large-blend and large-value were next with $17 billion and $4.5 billion, respectively, in outflows.
Yet there's reason to think that those who stuck with domestic large-cap funds will be rewarded. As Russel Kinnel recently noted in his annual "Buy the Unloved" study, the fund categories that get the most outflows in any given year tend to outperform the categories with the biggest inflows over the next several years. This is essentially a contrarian strategy, avoiding what's hot and going where others are stampeding for the exits. Domestic-stock funds are relatively unpopular now due to a general perception that most economic growth in the coming years will come from overseas, especially emerging markets such as China and India.
To be even more contrarian, we can look at large-cap funds that focus on "high-quality" stocks, meaning those that are stable and profitable with strong competitive advantages. Such stocks had a hard time keeping up in the rally of the past two years, which was largely driven by risky assets. A good proxy for quality, in this sense, is the economic moat ratings that Morningstar stock analysts assign to all the stocks they cover. A wide-moat stock has strong competitive advantages; a narrow moat means weaker competitive advantages; and stocks with no moat lack such advantages. Calculating the asset-weighted average moat rating for all the stocks in a fund's portfolio gives a good idea of the quality and stability of that portfolio.
David Kathman does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.