Buy the Unloved 2016

It's time for our annual "Buy the Unloved" report.

This is a strategy that we have tracked for more than 20 years, and it has proved to be surprisingly resilient. It's really a pretty basic contrarian strategy driven by mutual fund flows. The idea is to look at calendar-year mutual fund flows by Morningstar Category and go in the opposite direction.

The strategy says you buy funds in the three most redeemed categories and sell funds from the three most heavily purchased, then hold on for three or five years. Both time periods work well. Essentially, you use flows to point you to the most undervalued investment classes. Going back to 1994, the unloved have beaten the loved in all but one three-year period. On average, the unloved have beaten the loved by 377 basis points annualized.

I use flows for open-end funds and exchange-traded funds, but exclude funds of funds. The unloved categories for 2015 are pretty similar to those for 2014: large blend, large growth, and large value. That was a good signal last year, as large caps beat small caps, and large growth was particularly strong.

Here are a few good choices in each of the unloved categories.

Large Blend

Large Growth

For large-growth funds, I always plug Primecap, but you know that, so here are three non-Primecap funds that are well worth a look.

If you want a growth fund that can play defense, consider

Large Value

At

Feeling really contrarian? How about a good value fund with overweightings in energy and materials?

Sell the Loved On the flip side, foreign large-blend, Europe, and healthcare are the most loved categories. The Europe influx is particularly interesting. Nearly all the inflows came into dollar-hedged European ETFs, because Europe started a program of quantitative easing at the same time that it was apparent the U.S. Federal Reserve's next move would be to hike rates. Thus, investors interested in Europe were worried that a rising dollar would undermine any gains in equities. (Very few open-end Europe funds hedge their currency exposure.) So, I suppose this is a signal to bet against the dollar as much it is to bet against Europe.

I consider the "Buy the Unloved" strategy a good guide to contrarian ideas, but I wouldn't suggest overhauling your portfolio based on it. You don't want to veer from your overall, long-term plan. Just use this strategy at the margins and as a healthy reality check to make you reconsider buying the most popular categories and rethink selling a fund from an unpopular area.

For a list of the open-end funds we cover, click here. For a list of the closed-end funds we cover, click here. For a list of the exchange-traded funds we cover, click here. For information on the Morningstar Analyst Ratings, click here.