Unloved Categories for Contrarians
Three U.S. large-cap categories as well as U.S. small value saw the biggest outflows last year and could add a contrarian flavor to investors' portfolios, says Morningstar's Russ Kinnel.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Investors who like to take a contrarian tack with their portfolios might be interested in what fund types other investors have been selling recently. Joining me to discuss some data on this issue is Russ Kinnel--he's director of fund research at Morningstar.
Russ, thank you so much for being here.
Russ Kinnel: Good to be here.
Benz: Russ, you do this "unloved" study every year in Morningstar FundInvestor. Let's start by talking about how you do the study, in general. Are you incorporating open-end funds, active funds, index funds, ETFs--what goes into the mix when you look at what categories investors have been jettisoning?
Kinnel: That's right. I'm looking at open-end funds, ETFs--pretty much everything except we throw out funds of funds to avoid double counting and money market funds for obvious reasons.
Benz: So, the goal is to say--and you've got some data that point to this--that, over time, some of these categories that investors are selling do tend to go on to outperform. Investors are often responding to performance that hasn't been so good, but the categories sometimes recover and investors are rewarded for looking at some of these unloved categories. Let's talk about some of the categories that rose to the top when you looked at the data here at the end of 2015.
Kinnel: Interestingly, all three of the most unloved by total assets flowing out were U.S. large cap--large growth, large blend, and large value. That's even after factoring in the fact that, on the ETF side, we saw some net inflows, but on the open-end side, there was so much more in outflows that we still have large caps as the three most unloved categories.
Benz: What do you think investors are responding to there? It seems like there has been this ongoing antipathy toward actively managed funds, and U.S. large caps have really borne the brunt of that. Anything else?
Kinnel: I think you are right: A big part is the move against active. I think part of it is that some people are bearish on U.S. equities and more positive on emerging markets or some other areas. So, we've seen a few of these trends going together. And yet interestingly, in 2015 large caps did better than small and large growth, which is the most-redeemed category. Actually, it was one of the best places to invest--not that there was any really great area. But because we had some strong tech performance, large growth was actually one of the better places, and interestingly that's one of the places "Buy the Unloved" told us to invest a year ago as well.
Benz: Small value also hit the screen. Even though your screens were largely dominated by flows out of large caps, small value was there, too. What do you think is the reason?
Kinnel: I think this is a classic buy-the-unloved signal because small value was the worst place in the U.S. style box to invest--the reason being that small value has a lot of materials and energy companies. And of course, those that are less well funded, less capitalized, and have weaker balance sheets--which you tend to see in the small-cap world--were the most vulnerable to the decline in oil and other materials prices. So, small value was just a very vulnerable spot. And historically, we've seen that when oil and materials prices spike, small value often has a bit of a tailwind, and now we're seeing the reverse. So, I think people were just reacting to the losses we saw in small value this year.
Benz: Historically, have you noted that investors tend to mistime their purchases of small-value funds?
Kinnel: Well, the most famous instance would have been in 1999 when small value had positive returns, but they were dwarfed by the massive returns in large growth. Obviously, that was the Internet bubble--so boring, old small-value companies were shunned. Of course, as it turned out, 2000 was one of the greatest buying opportunities ever for small value. It did much better than the rest of the style box because it had gotten so cheap. I don't know that we are necessarily at that parallel, but small value does start to look more attractive as it underperforms. Obviously, you are making a bit of a contrarian bet because there are some materials names in there; but you can look for an individual fund that has energy and materials if you want to be a hardcore contrarian or you could look for a fund that has less of that and maybe wouldn't be hit so hard if commodities prices stay weak.
Benz: So, broad takeaways from this study: I probably don't want to upend my complete plan and venture into U.S. large-cap funds as well as maybe small value, but how should investors think about incorporating a little bit of a contrarian streak into their portfolio management?
Kinnel: I think you hit the nail on a head. This is a really good contrarian reality check. It tells you that, generally, you want to go against the grain. If you are buying the stuff that everyone else thinks is great, you are probably pretty late to the game and probably taking on some significant risks. If you go the other way, you're probably being a value investor and getting assets on the cheap. But again, I think it's something you adjust at the margins: Maybe you don't sell that large-cap fund you were thinking of or maybe you add a little more when you rebalance. I don't think it's a situation where you have all of your money sloshing back and forth in your portfolio over time.
Benz: Russ, the annual study in FundInvestor is out in the January issue. Thank you so much for being here to discuss it with us.
Kinnel: You're welcome.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.
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