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Buy the Unloved 2015

Going against the grain of flows can be a profitable strategy.

This article was published in the January 2015 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor here.

Our annual "buy the unloved" strategy points you to unpopular Morningstar Categories that may be due for a rebound. Historically, it has pointed to more winners than losers. The idea is to buy funds from the three unloved categories and sell three from the loved. You then hold the unloved for three to five years. Starting from 1993 and rolling it forward, the strategy returned an annualized 10.3% for unloved funds versus 6.4% for loved funds. I wouldn't suggest making wholesale portfolio changes, but rather make these changes at the margins or simply use this as a guide for where to shop or what to avoid when looking for new funds.

Although the strategy has done well over the long haul, last year's picks are in a pretty big hole. Large growth was a great spot to invest, but the other two categories were precious-metals equity and natural-resources equity. Ugh.

In 2014, the three most redeemed equity categories were large growth, mid-growth, and small growth. That's interesting, given that large growth was quite strong and even mid-growth had pretty good returns. Nonetheless, all three still have appeal. I don't want to push my luck with large growth, so I'll focus on funds with Morningstar Risk ratings that are Below Average.

Mid-Growth

Small Growth

Avoid the Loved What are the most-loved categories? Foreign large blend drew the highest flows in 2014, followed by large blend (U.S.) and conservative allocation. The strategy suggests dialing down exposure to these categories.

However, I'm not sure I'd go too far with that. All are core categories that you generally want to own through thick and thin.

So, I'm sharing the information for those who want to follow the strategy to the letter--but I wouldn't do it.

Historically, flows have followed performance, and that's why the strategy has been a winner. It leads you to relatively cheap asset classes and away from pricey ones. But since 2008, performance and flows have decoupled on the asset-class level even though they continue to be linked on a fund level.

Now flows are more linked to headlines. Since 2008, some people have taken a pessimistic (albeit incorrect) view of America's economy and looked to China as a superior bet. It hasn't worked that way the past five years, and it leaves us in the odd position of seeing the nature of fund flows change.

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