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Course 410
Buying the Unloved

Introduction

It can be hard to turn your back on a winner. Investors usually flock to those parts of the market with great returns. But chances are, those stellar returns won't last forever. Sears is no longer the nation's preeminent retailer, Seinfeld is no longer a top prime-time sitcom, and few of us are still walking around in double-breasted suits with ultra-wide ties.

Play against the crowd, though, and you just may catch a future trend today. Fund investors, as a group, have lousy timing. Most investors buy high and sell low, instead of the other way around. Opportunists can therefore make a bundle by buying what everyone else is selling.

So here's how to be an opportunist, the Morningstar way.

Morningstar's Unpopularity Contest

For our annual Unloved Fund study, we find the three most unpopular fund categories at the end of each year, based on percentage change in cash flows, or how much money is going into and out of mutual funds. We then recommend that you buy one fund from each unpopular category and stick with them for three years. Our study also highlights the most popular equity categories--those that have seen substantial new inflows--and suggests that investors trim back on those areas. Morningstar has featured this strategy to 1994 and found winning results. From the beginning of 1994 to the end of 2010, the unloved categories earned 308% cumulatively or 9% annualized. That's far better than the "loved," or popular fund categories, which earned 157% cumulatively or 6.1% annualized. The MSCI World Index returned 4.6% annualized, and the S&P 500 returned 8% annualized.

The Rules

Putting our unpopular-categories strategy into action is simple. In fact, there are just a fewrules to follow:

Buy one fund from each category.

Staking everything on just one unpopular category can be risky. Not every unloved category will catch fire, and one category can pull the weight for the entire group.

Have at least a three-year holding period.

You need a minimum of three years to employ this strategy. After you've accumulated your first batch of funds from unloved categories, plan to hang on to them for three years. At that point, you can roll the money into a new batch of unloved funds.

Limit your bets.

Resist the urge to put more than 5% of your portfolio into unpopular categories. That way you'll minimize the disappointment in one of those occasions when the strategy doesn't work.

Invest new money.

Maybe your company paid you a nice bonus this year, or maybe you have some cash you have been sitting on. Put that money to work by buying one fund from each of our unpopular categories for the year.

Sell one, buy the other.

If you are strapped for cash, try taking gains on popular fund categories and shifting the gains into out-of-favor categories.

Cut back on the favorites.

You'll do yourself a favor by simply reducing your exposure to popular categories. Do so with care, however, because selling your winners could trigger ugly tax consequences or mess up your asset allocation.

Look for Morningstar's list of popular and unpopular categories on Morningstar.com and in Morningstar FundInvestor (available in many public libraries) in the first quarter of each year.

Quiz 410
There is only one correct answer to each question.

1 Morningstar's unpopular-funds strategy works because:
a. Fund investors often have lousy timing.
b. Most fund investors have good timing.
c. Unpopular funds stay unpopular.
2 Unpopular categories are categories:
a. That have poor returns.
b. That don't have much money going into them.
c. That have terrific returns.
3 To improve your odds:
a. Buy one fund from one of the unpopular categories.
b. Buy one fund from each of the three unpopular categories.
c. Buy the top-performing fund in each of the unloved categories.
4 You should put how much of your assets into unpopular categories?
a. Just a sliver--no more than 5%
b. Twenty-five percent.
c. As much as you want.
5 What should you do about popular categories?
a. Buy more of them.
b. Sell them, no matter what.
c. Consider cutting back on them.
To take the quiz and win credits toward Morningstar Rewards go to
the quiz page.
Copyright 2006 Morningstar, Inc. All rights reserved.
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