Funds: Unpopular funds may bring the best rewards

reuters.com Mon February 24, 2003 12:31 PM ET (Clint Willis is a freelance writer who covers mutual funds for Reuters. Any opinions in the column are solely those of Mr. Willis.) By Clint Willis

BOSTON, Feb 24 (Reuters) - Mutual funds are not as well-liked as they were during the bull market, and some funds are downright detested. But the latter may offer the best opportunities for gains in the years ahead.

Chicago fund research company Morningstar, Inc. recently published results of its annual look at the market's most popular and unpopular fund groups. Over the years, the study has shown that investors who buy the least popular fund sectors often end up with market-beating returns.

Here's how the study works: Each January, Morningstar identifies the stock-fund categories that have attracted the largest cash inflows as well as the categories that have experienced the largest outflows during the previous calendar year. That done, they track the performance of both categories over the following three years. Then they compare results of the least- and most-popular categories.

Wouldn't you know it? Since 1987, the most hated fund groups have outperformed the most loved groups 90 percent of the time. Better yet, the unloved funds have outpaced the average equity fund 75 percent of the time.

For example, Morningstar analyst Josie Raney notes that 1999's least-popular funds came in these three groups: precious metals, Latin American stock, and convertibles. Investors abandoned those funds to buy red-hot technology funds. What happened? The unloved funds from that year have gained 0.54 percent annually on average in the last three years. That compares to an average annual loss of 26 percent on average for 1999's three most popular fund groups: technology, Pacific Asia ex-Japan stock and Japan stock.

Why do unpopular groups tend to outperform? One reason is that investors overreact to both good and bad news. As a result, the most popular sectors attract floods of money that drive share prices up to unsustainable heights. Meanwhile, share prices in unpopular groups often fall to levels that more than reflect any temporary problems in a sector. The result: bargains for contrary minded investors.

Bear in mind that a battered sector may be in for more trouble before it rebounds. Right now, investors are looking askance at utility funds due to heavy debt and excess competition, especially in the beleaguered telecommunications sector. Stock funds that invest in Latin American markets have been hit hard by political and economic problems in countries such as Venezuela and Brazil. Funds that invest in the financial services industry have suffered due to financial weakness and scandals in the brokerage and banking businesses.

It's not hard to make a case that such funds will continue to perform poorly in the immediate future. What's more, unpopular groups don't always bounce back strongly, even over longer periods. The superior returns earned by 1999's wallflowers have been driven largely by precious metals funds, up 17.0 percent annually during the three years through 2002. The other two unpopular groups have not done nearly as well. Funds that invest in Latin America lost 13.7 percent during that period, while convertible funds lost 5.3 percent. Those returns compare with an 10.4 percent loss for the average domestic equity fund.

Conclusion: A blindly contrarian approach doesn't always work -- especially not in the short run. One approach is to buy a mix of funds. Morningstar recommends dividing a modest sum -- less than 5 percent of your portfolio -- among shares from three funds: one each from the three unpopular groups.

Also be sure that you are willing to hold those shares for at least a few years, to allow time for a turnaround in the sectors. And if possible, make your trades in the shelter of an IRA or other tax-advantaged account. That way, you won't have to worry about capital gains taxes and the like when you trade.

Interested in trying the strategy? Morningstar recommends several funds in the current unloved groups: financial services, utilities and Latin American funds. Their favorites include T. Rowe Price Financial Services (down 10.1 percent in 2002), MFS Utilities (down 24.3 percent) and T. Rowe Price Latin America (down 18.1 percent).