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Buy the Unloved 2017

Leaning against flow and performance trends can be beneficial.

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This article was originally published in the January 2017 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor here.

For more than 20 years, Morningstar has recommended buying funds that others don't want as part of its "Buy the Unloved" strategy. This involves buying one fund from each of the three equity Morningstar Categories with the most calendar-year outflows and avoiding those with the most inflows. This contrarian approach asks you to put money to work in out-of-favor areas and to hang on for three to five years.

Over the long term, going against the crowd has improved results. Since 1993, the unloved groups have beaten the loved categories in most three-year periods. Overall, the unloved beat the loved by more than 5 percentage points annualized from 1993 through the end of December 2016. It works because investors often chase performance, thus signaling which areas may be overvalued or undervalued.

This year's unloved categories, based on flows for open-end and exchange-traded funds--excluding funds of funds--are large growth, European stock, and mid-growth. The categories to avoid in 2017 include large blend, foreign large blend, and diversified emerging markets. Here are some suggestions from the unloved:

Large Growth
 Vanguard Growth Index (VIGAX) offers cheap, diversified, pure exposure to this style and has been hard for active managers to beat over the long term. Primecap Management is one of the few shops that have been able to beat the index over time. Its experienced managers and contrarian, bottom-up brand of growth stock-picking has been a winning formula. The cheap  Vanguard Primecap (VPMCX), which has a Morningstar Analyst Rating of Gold, is closed to new investors, but Gold-rated  Primecap Odyssey Growth (POGRX) can still be had for a reasonable 65 basis points.

We're about eight years into a bull market, and it's fair to ask if the next big move is down. For some protection in that inevitability, consider Silver-rated  Jensen Quality Growth (JENSX). Its seasoned managers' focus on a handful of profitable businesses has weathered a lot of storms over 25 years.

European Stock
In 2015, European equity funds were among the loved categories. In 2016, Brexit spooked investors but also created opportunities for veteran managers with deep resources, such as Dean Tenerelli of Bronze-rated  T. Rowe Price European Stock (PRESX). For cheap, no-nonsense European equity exposure, Gold-rated  Vanguard European Stock Index (VEUSX), which charges a mere 0.12% for its Admiral and ETF shares, is hard to surpass.

In mid-cap growth, Chuck Akre is an uncompromising, bottom-up, buy-and-hold manager who invests in a handful of stocks trading at discounts to his estimate of their owner earnings, or profits left over after investments for upkeep and growth. Silver-rated  Akre Focus (AKREX) is pricey, but Akre has a terrific record here and at his former fund,  Hennessy Focus (HFCSX). Scott Brayman is a small-cap specialist who moved up-cap with some of his favorite holdings at Silver-rated  Champlain Mid Cap (CIPMX); he also has a great track record dating to his time running Sentinel Small Company (SAGWX) and was a nominee for Morningstar's 2016 Domestic-Stock Fund Manager of the Year award for his work at Silver-rated  Champlain Small Company (CIPSX).

 Vanguard Mid-Cap Growth (VMGRX) recently replaced one of its two subadvisors, but RS Investments' growth team's more-systematic risk control is an improvement over Chartwell Investment Partners. The steady William Blair still runs the other half of the Bronze-rated fund and can take a lot of credit for the fund's competitive long-term record. It's also the cheapest actively managed fund in its peer group.

"Buy the Unloved" can be a good guide to contrarian ideas, but the strategy is best reserved for a small portion of your portfolio. Use it on the periphery of your long-term asset-allocation plan. It can help you exercise the urge to "do something" when the market makes big moves and remind you of the power of rebalancing away from the most-popular categories and toward the unpopular ones.

Dan Culloton does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.