Buying Unloved Funds Could Yield Lovable Returns

Bill Gates is on the cover of Time. Steve Jobs headlines on CNBC. People may have laughed at them in the 1980s, but the computer whizkids of yesterday are laughing all the way to the bank today.

Sometimes the underdog wins in the mutual-fund world, too.

Every January, Morningstar FundInvestor finds the three least-popular fund categories from the previous year. We don't consider performance in our quest for unpopular categories; instead, we take a look at how the cash flow to each group of funds has changed in a given year. We then suggest buying one fund from each of these unpopular categories and holding it for the next three years. That means we're asking you to buy exactly what everyone seems eager to dump. It sounds unlikely, but we've found that these unpopular categories have beaten the average equity fund more than 75% of the time since 1987. Moreover, unpopular categories have beaten popular ones 90% of the time.

The results from 2000 are in, and you'll recognize a theme. This year, we recommend buying from the Pacific/Asia ex-Japan, diversified Pacific/Asia, and Japan categories.

This is new. There hasn't been a year since 1987 when the three least popular categories have been regionally focused offerings, let alone three categories that focus on the same broad region. But funds investing in Asia lost almost a quarter of their value in 2000--and they lost a lot of investors too.

That's partly because market turns in Japan and emerging Asia have been head-spinning. Let's start with Japan. The average Japan fund posted staggering returns in 1999 as the yen rose against the dollar. Spurred by positive first- and second-quarter economic growth that year, optimistic investors poured into the country's beleaguered markets. But the Japanese market faced an early correction in 2000, and many of these funds dipped sharply. The country's corporations have stalled on restructuring programs, quarterly economic data has slowed, and tech-sector issues--which reached sky-high valuations at the end of 1999--have imploded along with the Nasdaq. For the year, the average fund in the group lost about 35% of its value, and some of the category's more tech-heavy funds are down as much as 50% or more.

The situation is just as bad in emerging Asia. After rallying strongly in 1999, these markets dropped sharply in the aftermath of Japan's correction and continued to struggle throughout the year. Troubles in technology seeped into almost every sector, including the financial and manufacturing industries. Even larger markets, such as Korea and Taiwan, were down almost 60% and 50% respectively in 2000, and the average fund in the Pacific/Asia ex-Japan category lost more than 28%.

Hence the unpopularity of these categories.

Rules of Play
The process for implementing our strategy is fairly simple.

First: Muster the will to buy one fund from each category. Remember the whizkids? I knew a thing or two about computers and VAX accounts (early e-mail) when I was in high school, too. But you won't see me pulling up to the bank with a SUV-ful of cash. In much the same way, not every unpopular category will catch fire in the next three years. Investors who followed this strategy at the end of 1997, for example, bought a Pacific/Asia ex-Japan fund, a diversified Pacific/Asia fund, and a specialty-communications fund. Despite two Asian meltdowns in 1998 and 2000, the unpopular group still posted an average annualized return of 9.1%--nearly double the return of the popular group--thanks almost entirely to the communication category's 20% annualized gain.

This is particularly important this year. Don't buy a Pacific/Asia ex-Japan fund and call it a day. Japan's market doesn't necessarily move with the rest of the region: Emerging Asia's struggles could conceivably continue while Japan rallies strongly, forcing up the group's annualized return, or vice versa.

Second: Limit your investment. The unpopular categories often play in highly specialized markets--especially this year. Thus, your exposure to these funds shouldn't account for more than 5% of your portfolio. That way, you'll avoid serious trouble if 2000 turns out to be one of those years where this strategy doesn't work (though it would only be the second time). In 1996, for example, we suggested investors buy funds in the communications, precious-metals, and Europe-stock categories. This turned out to be something of a bust: Precious metals lost an annualized 18% over the next three years, dragging the unpopular average down to 10%, exactly half what the popular crowd returned.

Third: Use a tax-sheltered account. This isn't exactly day trading, but it will increase the turnover--and the possibility of ugly tax penalties--in your portfolio. A Roth IRA might be a good choice.

Finally: If you can, buy soon. Morningstar studies have shown that generally, you can buy the funds up to a year later and the strategy will still work. Still, prices in Asian markets have been largely driven by momentum investors in recent years, so they can get expensive very quickly. In this case, then, it might be best to buy early while stock prices are still low.

We know that it's going to be difficult to commit to our three choices this year; Asian markets look pretty miserable right now. Here are some approaches that might help ease your anxiety.

Two Ways to Play
Invest some new money: Perhaps you've recently received a bonus or a raise. Or maybe you're going to return some of those holiday presents for cash. Don't sit on your windfall; instead, put it to work buying one fund in each of the unpopular categories.

Scale back on favorites: If this strategy works as well this year as it has in the past, you'll be glad that you trimmed your portfolio's exposure to overbought categories. The stars of 2000 have been specialty-health, mid-cap growth, and specialty-technology funds. Trim them and move assets to our unpopular categories.

Final Notes
If you've been following this strategy since 1997 or 1998, you're probably throwing up your hands in exasperation. After all, you're probably ready to sell your Pacific/Asia ex-Japan and your diversified Pacific/Asia funds--two of the unpopular funds in 1997--after a year like 2000. Don't. Instead, take any profits you might have gained. But keep the principal in the fund.

Here's just one reason to follow that advice. Investors are generally fickle, so it's possible that a category will fall from grace very fast. In 1999, for example, investors couldn't get enough Japan exposure. (And no wonder; the average Japan-stock fund returned more than 116% for the year.) This year, fair-weather investors fled the category. Thus, if you had followed this strategy, you would have sold the Japan category at the end of 1999, only to turn around and buy it back at the end of 2000. This is a perfect example of why it's best not to sell your whole stake in popular funds--instead, take profits.

If you're interested in putting our strategy to work in your own portfolio, you may want to check out what Morningstar analysts have to say about the funds in each of the unpopular categories. View the Analyst Picks in the Pacific/Asia ex-Japan, Diversified Pacific/Asia, and Japan Stock categories.

If you're adverse to having these "specialty" funds in your portfolio, if this all seems a little too risky and time-consuming, or if you aren't able to cover the minimum investments on three funds, you might be interested in the more-moderate version of our strategy. Click here to find out how to rebalance the core of your portfolio according to our "unpopular" approach.

Stephen Murphy contributed to this article.