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Buy the Unloved: 2020 Edition

A simple contrarian investing strategy to consider.

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A version of this article appeared in the January 2020 issue of Morningstar FundInvestor. Download a complimentary copy of Morningstar FundInvestor by visiting the website.

Update: In a previous version of the report, we reported the Loved and Unloved Morningstar Categories that resulted from mutual fund flows excluding exchange-traded fund flows. In the update below, we take into consideration both mutual fund and ETF flows.

The corrected report results in no changes to the Unloved Categories in Version 1. The Loved categories in Version 1 were previously foreign large blend, diversified emerging markets, and world small/mid stock. In the corrected version that considers ETFs, the Loved Categories include large blend, foreign large blend, and diversified emerging markets.

In Version 2, we saw more changes when we took into account ETF flows. Incorporating ETF flows changes the Unloved categories from bank loan, long government, and healthcare to bank loan, financial, and European stock. The Loved categories also saw a change. Previously, these were muni national intermediate, intermediate core bond, and high-yield muni. In the corrected version the Loved categories are: intermediate government, muni national intermediate, and world-bond USD hedged.

It’s that time of year when we suggest investors go against the grain and buy the unloved.

We are one year removed from an update to the long-standing Buy the Unloved contrarian investing strategy. We’ve kept the original iteration, launched in 1994, in this report but have supplemented it with another edition.

The original strategy involves investing equal sums in the three equity Morningstar Categories with the largest calendar-year outflows (in dollars) in the previous year. After three years, sell the stakes and invest the proceeds equally in that year’s unloved categories. The idea is that areas of the market experiencing outflows may be out of favor, perhaps overly so. In this way, we hope that this contrarian strategy can direct investors to cheap parts of the market. While imperfect, as it uses flows rather than valuation, the strategy’s success over the long haul suggests that there is some merit to it. We exclude those categories where flows are less useful indicators, such as the target-date, trading, and leveraged categories. Buy the Unloved is long only and long-term-oriented.

We benchmark the results of this version against the world large-stock category. While it has worked well, we expanded our methodology last year to include a broader set of categories and factor in the percentage change of flows, not simply absolute flows. We call this Version 2. To recap, this version includes bond and allocation categories, and equal-weights dollar flows and the percentage change in assets to determine the Loved and Unloved categories. Given the inclusion of fixed income, a new bogy is appropriate. We’ve chosen a custom index that’s 60% MSCI ACWI and 40% Bloomberg Barclays US Universal (a broad fixed-income standard).

Now that the groundwork is laid out, let’s look at this year’s results.

In Version 1, which used net flows in open-end and exchange-traded funds through December 2019, the year’s most unloved equity categories were large growth, large value, and world large stock. By contrast, the most popular categories were large blend, foreign large blend, and diversified emerging markets. Below are some ideas for investing in this year’s Unloved categories.

Large Growth
Large Growth T. Rowe Price Blue Chip Growth (TRBCX) is a best-in-class option and earns a Morningstar Analyst Rating of Gold. The combination of a skilled manager and analyst team is a potent mix. Veteran manager Larry Puglia launched the strategy in 1993, navigating well through multiple market cycles. He spreads the portfolio across more than 100 stocks and in recent years has benefited from strong stock picks in the technology sector. The strategy has stayed a notch above the benchmark despite a tough environment for active equity managers and is a great option for investors.

Investors who prefer a passive option should consider Vanguard Growth Index (VIGAX). It earns a Silver rating and is one of the cheapest large-growth funds available.

Large Value
Large-value investors have been dumping value strategies for quite some time as they’ve struggled to keep pace with growth. Silver-rated DFA US Large Cap Value (DFLVX) is a strong passive option. Its deep-value tilt means that the fund courts more risk than its typical peer but offers investors broad exposure at a relatively low cost. The managers target the cheapest 30% of stocks based on their price/book ratios after filtering out highly regulated utilities, REITs, and companies in bankruptcy.

For investors seeking more traditional, bottom-up stock-pickers, Diamond Hill Large Cap (DHLAX), which boasts a Gold rating, is a great option. The fund adopts a relative value approach and often lands in the large-blend portion of the Morningstar Style Box. In addition to its focus on valuation, the team also hunts for quality and durability. It looks for businesses with stable cash flows and defensible competitive advantages. Bottom-up stock-picking has rewarded investors over time.

World Large Stock
In the world large stock category, Silver-rated Vanguard Total World Stock Index (VTWAX) is a low-cost way of gaining exposure to global stocks of all sizes. This passive fund’s well-diversified portfolio and ultra-low expense ratio are just some of its advantages.

For investors seeking alpha, Gold-rated American Funds New Perspective (ANWPX) is a strong choice. Since its March 1973 inception, the fund has sought to invest in firms poised to benefit from changing global trade patterns. It has done so successfully, and its track record has been exceptional over time. American Funds’ multimanager approach helps to handle this fund’s $100 billion asset base, the world large stock category’s second largest.

Version 2
Under our modified methodology that factors in flows as a percentage of total net assets, we arrive at a different cohort of categories. By this measure, 2019’s most unloved categories were bank loan, financial, and Europe stock. Conversely, the most popular categories of the year were intermediate government, muni national intermediate, and world-bond USD hedged. We look at some options for investing in this other contingent of unloved categories.

Bank Loan
The bank-loan market is risky, and funds in this space tend to be volatile. For a more conservative bank-loan strategy, Bronze-rated Eaton Vance Floating Rate (EVBLX) is a solid choice. The team’s focus on fundamentals and capital preservation has paid off over time. They take a measured approach and don't hold large CCC-rated loan stakes, arguing that they have generally not paid enough to offset their higher default rates. Although it invests in a volatile area of the market, this fund can serve a supporting role in a broadly diversified portfolio.

Financial
Silver-rated Davis Financial (RPFGX) is a strong sector fund. The team boasts robust analytical resources with deep expertise in the financial sector. Together, they look for companies in the financial sector that are trading at discounts to their intrinsic value estimates. The fund prefers firms with defensible competitive edges--such as innovative products, high switching costs, and trusted brands--run by executives who know how to protect and extend them. This discipline has rewarded investors with a stellar long-term record on the back of strong stock picks. Since this is a specialty fund, though, you wouldn’t want to make it a big part of your portfolio.

Europe Stock
On the back of challenged economic growth in the region, the Europe stock category has seen net outflows. Silver-rated Invesco European Growth (AEDAX) is a fine choice for investors. It boasts an experienced and stable management team, and a measured approach that has tended to limit losses in downturns. As with many other Invesco international funds, this fund's approach can be characterized as a moderate take on growth. The team looks for high-quality companies with sustainable earnings growth that are trading at a reasonable valuation across the market-cap spectrum. It applies a patient approach and does not hedge its foreign-currency exposure. Its approach has paid off with strong stock picks rewarding investors over time, but its regional focus means that this fund should not be a large part of your portfolio.

Conclusion
Buy the Unloved isn’t a total portfolio investing strategy, and it does not work 100% of the time. Outflows don’t make funds themselves any cheaper, but they might indicate which market sectors are unpopular and ready to recover. It is also useful to consider the contrary case at a time when our own biases tend to point us toward buying the best-performing funds.

Linda Abu Mushrefova has a position in the following securities mentioned above: TRBCX. Find out about Morningstar’s editorial policies.