MUTUAL UNDERSTANDING - Unloved funds warrant attention - Big outflows may highlight future gains, says Morningstar
cbs.marketwatch.com By Craig Tolliver, CBS.MarketWatch.com Last Update: 3:11 PM ET Jan. 13, 2003
CHICAGO (CBS.MW) -- The founder of the Templeton Funds once said, "Outperforming the majority of investors requires doing what they are not doing." His solution: buying when pessimism is at its maximum.
Putting John Templeton's dictum to the test, Morningstar is out with its annual survey of "unloved funds" that saw last year's biggest loss of assets under management. The Chicago-based fund tracker first introduced the study in 1996, after tracing fund flows back to 1987.
Morningstar discovered that the funds from the most unpopular asset classes each year outperform the average equity fund over the following three years more than 75 percent of the time.
Moreover, unpopular funds have outpaced popular ones more than 90 percent of the time.
"Buying one fund from each of these categories and sticking with them for a few years has been a profitable investment for those who have the patience and willpower to handle contrarian investing," said Christine Benz, editor of Morningstar FundInvestor.
This year's least popular fund categories include:
- Latin America: For the second straight year, Latin America funds got no love from investors, thanks to concerns over Brazil's political and economic volatility and continued instability in Argentina and Venezuela, Morningstar noted.
- Utilities: Enron and the California energy debacle; WorldCom and the general blowup of the telecom sector topped the agenda.
- Financials: Money-center banks, asset managers and brokerages were stung from the three-year bear market. Seemingly unnoticed, however, were funds focusing on regional banks, which had a stellar year -- such as Senbanc (SENBX: news, chart, profile), up nearly 19 percent in 2002. See table below.
"We understand that some investors may be skeptical about funds in these categories, but we believe they're likely to turn around in the upcoming years," Benz said.
"While the categories that are garnering the most new inflows these days -- precious metals, small-value, and real estate funds -- may seem more appealing, our research indicates funds from unloved categories for a given year actually outperform popular fund categories during the three following years," Benz added.
For those that find the Unloved Funds theory intriguing, Morningstar offers the following advice:
Buy one fund from each of the three unpopular groups
Not every downtrodden category will rally during the next three years, so diversifying with a small stake in each group can be key. For example, Latin America funds, which Morningstar named as one of its unloved categories in early 2000, have continued to lag, while precious-metals funds have been strong. Exposure to all three categories increases the chances for market-beating returns.
Hold for three years
Don't expect instant results. Gold fund investors in early 2000 might have been tempted to dump them after losing an average 17 percent that year. But, metals funds went on to garner large gains in 2001 and 2002.
Limit the investment
Since unpopular categories frequently dabble in highly volatile markets, limit exposure to these funds to no more than 5 percent of your portfolio. And while the strategy has been highly successful, it's not foolproof.
In 1995, for example, Morningstar suggested investors buy funds in the communications, precious metals, and European-stock categories. Because of a terrible showing from the precious-metals funds, the unpopular group posted a three-year annualized return of only 10 percent -- half the gain of the popular funds.
If possible, buy soon
Morningstar studies have shown that, generally, investors can buy the funds up to a year later and the strategy still works. However, all three unpopular categories for 2002 are vulnerable to market-timers, so in this case, the analyst suggests buying while stock prices are low -- before timers can swoop in and push prices up in a hurry.
Top performing Unloved Funds
The funds below were the best performing funds of their respective "unloved" asset classes and are provided for reference and not as a recommendation from Morningstar.
Latin America Name Ticker 2002 Return 3-Yr Return Templeton Latin Amer (TELAX: news, chart, profile) -16.98 -9.56 T. Rowe Price Latin Amer (PRLAX: news, chart, profile) -18.10 -10.14 Scudder Latin Amer (SLAFX: news, chart, profile) -18.28 -11.90 Latin America Category -20.18 -13.77
Source: Morningstar, data annualized through December 2002
Utilities Name Ticker 2002 Return 3-Yr Return Franklin Utilities (FKUTX: news, chart, profile) -10.48 5.23 Eaton Vance Utilities (EVTMX: news, chart, profile) -12.50 -8.93 Principal Utilities (PUTLX: news, chart, profile) -12.73 -9.51 Utilities Category -23.81 -12.86
Source: Morningstar, data annualized through December 2002
Financial Services Name Ticker 2002 Return 3-Yr Return Senbanc (SENBX: news, chart, profile) 19.79 18.96 FBR Small Cap Financial (FBRSX: news, chart, profile) 18.68 24.86 Burnham Financial Svcs (BURKX: news, chart, profile) 17.55 32.42 Financials Category -10.58 4.25
Source: Morningstar, data annualized through December 2002 Craig Tolliver is the mutual funds editor for CBS.MarketWatch.com in Los Angeles.