Unpopular Funds Yield Surprising Returns

Buying what’s popular is usually a bad idea. Instead, look closely at the unloved parts of the market for clues about where to best invest your money.

As is so often the case, Warren Buffett put it best. “The future is never clear; you pay a very high price in the stock market for a cheery consensus,” he said.

Look at the record. From 1997 through 2000, individual investors poured about $775 billion into domestic stock funds. In contrast, investors yanked some $400 billion from domestic stock funds from 2008 through 2011, including $93 billion last year alone. So perhaps U.S. stocks will continue to rally from here (as of February 9, Standard & Poor’s 500-stock index had climbed 24% since bottoming last October 3).

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Morningstar takes a more specific approach to flows in and out of funds. Since 1993, the investment research firm has tracked the subsequent three-year performance of the three least loved and the three most loved fund categories.

The results are striking. The unloved funds returned an annualized 8.9%, while the loved funds returned just 6.5%. Over the same period, the S&P 500 returned 8.4% annualized, and the MSCI EAFE index, which tracks stocks of mainly large companies in developed foreign markets, gained 5.2% a year.

Here’s a look at how this pattern has worked in the not-too-distant past. In 2006, investors dumped health care, mid-cap growth and technology funds more than any other fund categories. That same year, they piled into foreign large-company blend funds, foreign large-company value funds and world stock funds, which invest in both U.S. and foreign stocks.

From 2007 through 2009, the three unloved sectors lost an annualized 0.5%. That wasn’t great, but the most popular categories plunged an annualized 5.7% in a period that included the worst bear market since the Great Depression. The S&P 500 lost an annualized 5.6%, and the EAFE index dropped an annualized 6%.

Like any strategy, buying the unloved doesn’t work all the time. When the market is on a multiyear roll, buying the loved categories works better. In 1997, as a financial crisis got under way in Asia, the three categories investors exited most feverishly were Asia funds that don’t invest in Japan, Asia funds that do include Japan, and utility funds. Investors piled into three domestic groups: large-company blend, large-company value and small-company value funds.

Three years later, the three unloved categories had returned an annualized 8%. That’s not too shabby. But the loved categories had gained 8.8%. The S&P rose an annualized 12.3%, and the EAFE index climbed an annualized 9.4%.

Russ Kinnel, director of fund research at Morningstar, says the strategy of investing in the least popular sectors works best in the “pivot years.” By that, he means stretches like the 2000-02 bear market, during which tech stocks, after being on fire for years, suddenly collapsed and investors rediscovered small-company stocks and value stocks.

In 1999, investors bailed out of all value funds -- regardless of the size of the companies they focused on. Where did they put their money? Into large-company growth, large-company blend and technology sector funds.

Over the subsequent three years, those unloved value funds returned an annualized 1.5%, while the rest of the market melted down. The S&P 500 tanked an annualized 14.6%, the EAFE index tumbled 17.2%, and the previously loved categories plunged an annualized 22.7%.

It makes little sense to use this strategy in isolation. “Don’t go out and gut your portfolio because of it,” cautions Kinnel. Instead, it’s a “reality check. It points you toward what’s cheap and away from what’s expensive. It’s a sound contrarian strategy.”

Indeed, from a valuation perspective, selling tech in the late 1990s and buying value stocks made perfect sense. Price-earnings ratios for tech stocks were insanely high, and many tech stocks were bid up even though they had no earnings. At the same time, value stocks were much better values than usual; many were dirt-cheap.

What’s most loved and unloved today? In 2011, investors sold $40 billion of large growth funds, $23 billion of large blend funds and $16 billion of global stock funds (which mainly invest in stocks of developed nations). Meanwhile, investors bought $20 billion in emerging-markets stock funds, $9 billion in commodities funds and $4 billion in foreign large-company growth funds.

Steve Goldberg (bio) is an investment adviser in the Washington, D.C., area.