Skip to Content
Investing Specialists

A Ticket to Success for Fidelity Investors

Funds in yesterday's unloved categories may be tomorrow's winners.

In his 2004 book The Wisdom of Crowds, columnist James Sourwiecki of The New Yorker explains why the masses often get it right. But as a natural contrarian, I was more interested in instances where the crowd gets it wrong. As an example of the latter, Sourwiecki describes an experiment where a man stood at the corner of a busy city street, gazing upward, looking at nothing in particular. Others followed the man's lead, and eventually, a good-sized group had gathered, all staring in the same direction. There wasn't anything interesting or unusual to see, but the gathering grew large because everyone in it thought that there was. Each person had decided to join the group solely because others already had. The bigger it became, the more likely it would attract ever more passer-byes, creating, as Sourwiecki notes, a classic "information cascade."

The crowd of Sourwiecki's sky-gazers simply wasted a minute or two. But in investing, the consequences of following the crowd could be a lot more costly. Because many investors chase performance, money tends to flow to funds where returns have been strongest, meaning newcomers miss out on the past gains. Conversely, they flee from those where returns have been weakest, often to miss an eventual rebound. The result is the opposite of what you'd expect from a perfectly rational market. Dollars should move from popular asset classes, which are typically more expensive, to those that are cheaper. But for awhile, at least, the opposite happens. Investors migrate to the most popular and priciest areas of the market. As a result, Morningstar's research finds that fund categories with the greatest recent inflows tend to underperform longer term, while those with the greatest recent outflows tend to shine in ensuing years.

As it happens, there's a pretty good way to make money off this phenomena. Since 1994, Morningstar's director of fund research (and Morningstar Fund Investor editor) Russ Kinnel has tracked a strategy named "buy the unloved," which involves investing in the three equity categories with the highest levels of outflows over the past 12 months, while trimming back or selling the three most popular equity categories, as indicated by the highest recent inflows.

To employ the strategy, you'd buy funds from the three least-popular categories, doing so next year and the year after that, too. After accumulating three groups of unloved categories, you roll money from the earliest group into a new one, resulting in a three-year holding period. It's tough to argue with the results: From 1994 through 2009, the buy-the-unloved strategy delivered an 8.1% annualized return, versus 4.8% for the loved, 6.3% for the S&P 500 Index, 6.96% for the Wilshire 5000, and 5.36% for the MSCI World.

Over the past 12 months, the most-unloved equity categories have been large growth, large value, and world stock, while the most loved have been foreign large-blend, diversified emerging markets, and Pacific Asia ex-Japan. Thanks to Fidelity's sprawling lineup, it's pretty easy to employ the buy-the-unloved strategy at the firm. Keep in mind that you don't need to precisely follow the strategy for it to be successful. At the very least, consider this article a guide to where you should be currently deploying free cash.

The best of the unloved
By many measures, the large-growth category's recent slump is a contrarian's dream. It's the most unloved, with the highest level of shareholder redemptions of any fund category over the past year. Performance has been downright terrible for an entire decade. Through April 2010, the typical fund in the category is down 1.2% annually over the past 10 years, versus a roughly break-even showing for the S&P 500 Index. The excess enthusiasm for the category a decade ago is long gone.

Fidelity's lineup is heavy on large-growth fare, including some top-rate options.  Fidelity Contrafund  (FCNTX) is hardly a secret; manager Will Danoff's long-term record is among the category's best. But I especially like it in today's environment. Companies with iffy fundamentals rallied most sharply last year, leaving higher-quality fare more-attractively priced. And Danoff has been emphasizing the latter; Contrafund's average moat rating, which is based on Morningstar equity analysts' assessment of companies' long-term competitive advantages, is among the highest of any Fidelity large-cap fund.

Two lesser-known large-growth funds also worth considering are  Fidelity New Millennium (FMILX) and   Fidelity Fifty (FFTYX). Both are far smaller than Contrafund, giving their managers the freedom to employ wider-ranging strategies. While New Millennium's John Roth avoids sector bets, he invests across all market caps and more recently revealed an opportunistic streak. In 2008's slump, he bought beaten-down tech and industrials stocks, fueling his fund's 2009 resurgence. (Roth has since pared back his bets on economically sensitive fare.) Fifty's Peter Saperstone has followed a similar playbook. Saperstone rightly emphasized racier fare in 2009, but he's dialed back more recently, shifting into higher-quality industry leaders. The fund is more concentrated than most Fidelity offerings (as its name implies, it has about 50 holdings), so it can be volatile. But if you can handle that, it's can be a nice way to supplement the core of your portfolio.

As someone whose investing career came of age in the late 1990s and 2000s, I think it odd that both large-growth and large-value are unloved at the same time. Throughout the past two decades, at least one was in favor. But many large-value funds got caught holding a big helping of financials during the credit crisis, damping investor enthusiasm for them. The most contrarian way to play large value would be through a dividend-oriented fund such as  Fidelity Equity Income (FEQIX). Dividend payers have been out of fashion as cheaper, more-speculative fare ruled the roost.

The third least-popular category, world stock, is a bit of a hodgepodge. It contains funds with varying regional exposures, investment styles, and market-cap focuses. As such, world stock isn't as precise an investment category as large growth or large value. In any case, I'm not convinced Fidelity's lone world-stock offering,  Fidelity Worldwide (FWWFX), is the way to invest in the group. As an alternative, I'd consider  Oakmark Global  (OAKGX), which is available on Fidelity's no-transaction-fee brokerage platform. Its concentrated, deep-value style also isn't something you'll find much of at Fidelity. Management's contrarian style also means you're getting a basket of unloved stocks. (The fund's stake in out-of-favor Japan, for example, is higher than nearly all of its peers'.) Execution, too, has been superb, with long-term returns ranking near the top of the category. Fidelity Worldwide, by contrast, has been middling.

Loved Too Much
If outflows are a reliable guide to what's undervalued, then inflows should be an indicator what's overheated or at risk of overheating. The categories with the greatest inflows over the past year have been foreign large blend, diversified emerging markets, and Pacific Asia ex-Japan. Just as I wouldn't advocate betting big on the unloved categories, I'm not arguing you abandon the too-loved altogether. Foreign large blend and emerging markets both make sense as part of a diversified portfolio. However, you might want to pare back your holdings in both if you haven't already. As for Pacific Asia ex-Japan, I'm turned off by its narrow regional mandate. Moreover, Fidelity's fund in the category,  Fidelity Southeast Asia  (FSEAX), has experienced considerable manager turnover in recent years. The resultant strategy shifts and the varying quality of different management teams have made the fund difficult to own.

And while the buy-the-unloved study focuses on equities, there's no reason why its fundamental lesson wouldn't be true for bonds. That's especially worth keeping in mind now, as the hottest categories of all over the past year have been in the bond arena. Bond funds had record inflows in 2009 even though they had so resoundingly beaten stocks over the previous decade--a historical anomaly (the last time that happened was in the 1930s). I'm not advocating shunning bonds altogether; just like foreign large-blend or emerging-markets funds, they make sense as part of a long-term asset allocation. But with historically outsized returns and the looming specter of rising interest rates, I'd invest cautiously.