Buy the Unloved: 2019 Edition

This article was originally published in the January 2019 issue of Morningstar FundInvestor.

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Buy the Unloved is a contrarian investment strategy that has done well over 25 years, but it's getting an update in 2019. Launched in 1994, the strategy involves investing equal sums in the three equity Morningstar Categories with the largest calendar-year outflows (in dollars) the previous year. After three years, sell the stakes and invest the proceeds equally in that year's unloved categories.

This against-the-grain approach can lead you to cheap parts of the market that may be due for a rebound, albeit indirectly, because it looks at flows rather than valuations. We exclude those categories where flows are less-useful indicators, such as the target-date, trading, and leveraged categories. It is long-only and long-term-oriented.

The tactic has worked well. Using category averages to track returns and starting in 1999 (the earliest date for benchmark data), investors who bought 1998's unloved categories and rebalanced through the years earned 4.8% annualized through December 2018. That topped a mirror strategy that invested in those years' loved categories and beat the diversified MSCI ACWI global-equity index by 0.3 percentage points. Simply investing in the category indexes worked just as well. In fact, 15 of the strategy's 20 iterations since 1999 have outperformed the index.

Yet there's room for improvement. For one thing, looking at flows as a percentage of a category's total assets--rather than net dollar change--offers another glimpse of investor sentiment. Another improvement expands the list of eligible categories. The strategy's parameters need not preclude many fixed-income funds (except near-term investment categories such as ultrashort bond).

So, 2019's edition of Buy the Unloved offers two versions of the strategy: 1) the traditional equity-only version based on net flows and 2) a new option that includes nonequity categories and equal-weights dollar flows and the percentage change in assets. The former will benchmark to the MSCI ACWI, the latter to a custom index that's 60% MSCI ACWI and 40% Bloomberg Barclays U.S. Universal (a broad fixed-income standard).

Using net flows in open-end and exchange-traded funds through December 2018, the year's most unloved equity categories were large value, large growth, and Europe stock. By contrast, the most popular categories were foreign large blend, large blend, and diversified emerging markets. Here are some options for investing in the unloved categories.

Large Value Value stocks haven't been in favor lately, and the flows show it. If they are due for a rebound, consider Schwab Fundamental U.S. Large Company Index SFLNX, which has a Morningstar Analyst Rating of Bronze. This strategy offers broad, inexpensive large-value exposure. It adds stocks trading at low multiples of sales, dividends plus share buybacks, and other fundamental metrics. Dynamic rebalancing shaves off expensive holdings. A reasonable price tag helps, and there's an ETF vehicle: Schwab Fundamental U.S. Large Company ETF FNDX.

For those who prefer stock-pickers, Gold-rated Dodge & Cox Stock DODGX is an excellent choice. The fund's proficient investment committee hunts for bargains among firms with good management, competitive advantages, and solid growth potential. Such scrutiny enables a buy-and-hold strategy that keeps transaction costs down, making it one of the cheapest actively managed options.

Large Growth Despite a run of outperformance versus value, investor selling has put the large-growth category on the unloved list since 2004. The FAANG stocks-- Facebook FB, Apple AAPL, Amazon.com AMZN, Netflix NFLX, and Google parent Alphabet GOOGL--have led the large-growth charge. If these and other market leaders still have upside, then Silver-rated Vanguard Mega Cap Growth ETF MGK offers a cheap and well-diversified way to play them. A penchant for more-profitable firms gives the fund a backstop if growth cools off.

For an idiosyncratic take on growth, check out Akre Focus AKREX. This Silver-rated fund's eclectic, concentrated portfolio's largest holding is a telecom company: American Tower AMT. Visa V and Mastercard MA dominate its information technology stakes. The fund's managers keep volatility in check, and their focus on cash-generating firms favors long-term growth investors.

Europe Stock A simple way to enter the complex European market is Vanguard European Stock Index VEUSX. This Silver-rated fund offers broad geographic, market-cap, and sector exposure in developed Europe. The index it tracks promotes diversification by including small caps with exposure to local markets. Yet a word of caution: The fund doesn't hedge its currency risk, introducing volatility as exchange rates waver.

Version 2.0 Factoring in the effect of flows on a category's total assets reveals a different picture of investor sentiment. On that measure, 2018's most unloved categories were Europe stock, high-yield bond, and financial. Conversely, investors loved long-government bonds and two equity categories: foreign large blend and China region. Having already considered a European stock fund, let's look at the other unloved categories.

High-Yield Bond Investing in junk bonds obviously courts risk, but Vanguard High-Yield Corporate VWEHX suits the more cautious--and cost-conscious--investor. This Silver-rated fund favors higher-rated debt, yet its deep team can pore over company financials to make bold calls. All this comes with one of the category's lowest expense ratios.

For a more aggressive approach, try Silver-rated Fidelity Capital & Income FAGIX. The fund delves into the lower-quality tiers of the junk-bond market at times, and a hefty equity allocation augments returns for better or worse. That said, the fund's manager has proved adept at making timely moves to cash, trimming its junkiest debt. While 2018 was rough, the fund has a propensity for sharp rebounds.

Financial For a concentrated sector fund, Silver-rated Davis Financial RPFGX manages to offer healthy diversification. Its modest portfolio downplays commercial banks to accommodate positions in insurers, asset managers, and consumer finance. There's also some non-U.S. exposure. Davis Advisors has a rich history of investing in financials, and it was among the earliest shareholders of Warren Buffett's Berkshire Hathaway BRK.A, a top-five position here. In fact, Buffett-like preferences for margins of safety and competitive advantages pervade this fund's process.

Conclusion Buy the Unloved isn't a total-portfolio investing strategy. Outflows don't make funds themselves any cheaper, but they might indicate which market sectors are unpopular and ready to recover. This strategy captures that intuition. It checks our enthusiasm for popular categories and reminds us to look at shunned ones.