Christopher Davis: Contrarian thinking doesn't come naturally to most investors. They buy what's done well recently and sell what hasn't. This behavior makes strong performers more expensive and weaker performers cheaper. This cycle typically doesn't last forever though. Eventually, what's become too popular becomes too expensive, and what's become unpopular too cheap, and the process reverses itself. That's the idea behind our "buy the unloved" strategy.
In every January since 1994, we've looked back over the past year and identified the three least popular fund categories as measured by fund flows. The idea is that the least popular categories are most likely to be undervalued. Investors targeting them should benefit when the sentiment turns.
That's been the case historically. We've tested the performance of the three least loved categories by comparing the results to those of the three most loved categories over three-year periods. To measure our results, we assume investors buy funds from each of the unloved categories, hold them for three years, and repeat the process. Since 1994, the unloved categories have beaten the most popular ones by more than 5 percentage points annually.
The three equity categories that saw the heaviest outflows last year were large growth, large value, and mid value. If you want to follow our strategy, these would be the categories to target. The ones to avoid are large blend, foreign large blend, and diversified emerging markets. They had the heaviest inflows in 2017.
This isn't to say that you should dump your large blend or emerging-markets funds and go whole hog into large growth or mid value. Make sure what you do is in line with your long-term asset allocation. What we are saying is that as you rebalance your portfolio, consider cutting your emerging markets or large [blend] exposure in favor of funds from unloved categories. What's been in other investors' discard pile is like to be tomorrow's winners.
For Morningstar, I'm Christopher Davis.