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Kathy Panagopouloskathy.panagopoulos@morningstar.com
'Unloved Funds' Formula Works: Morningstar Data Show Upside of Contrarian Strategy

CHICAGO, Jan 20, 2004 – With the stock market rebounding sharply from bear-market lows, investors are returning to mutual funds. Rather than follow the crowd, taking a contrarian approach can lead investors to unearth some bargains.

Morningstar, Inc.’s eighth annual “Unloved Funds” study demonstrates that out-of-favor funds can often reap better returns than their more popular counterparts. The study’s findings were released today in the January issue of Morningstar FundInvestorTM, a monthly newsletter for individual investors.

At the end of each year, Morningstar reviews how money has flowed into and out of each of the company’s 20 domestic-stock mutual-fund categories. Consistently, the funds identified as “least loved” each year tend to outperform the year’s more popular funds over time.

“Going against the crowd is seldom easy. It requires patience and long-term thinking, but that is true of just about any successful investment strategy,” said Russel Kinnel, editor of Morningstar FundInvestor. “The historical results of our study show that such a contrarian stance can often be rewarding.”

In 2003, the least-popular fund categories included:

  • Utilities – For the second straight year, investors avoided this sector, which has had fewer distributions and more volatility. These funds were not only the most unloved, but also among the worst-performing.
  • Financials – Also in their second year as a “most unloved” sector, funds in the financial sector actually performed above average in 2003. Although they were strong bets during the recession, these funds did not dazzle investors during the market rebound and have instead been upstaged by better-performing funds.
  • Communications – This sector has been humbled by mountains of debt, overcapacity, and brutal competition. The sector rebounded in 2003, but long-term investors still lost money during the past three to five years.

To determine a year’s most “unloved” funds, Morningstar analysts identify which funds have had the most inflows and outflows from the previous year as a percentage of total assets. The funds with the most inflows are the “most loved,” and those with the most outflows, the “least loved.” Morningstar has found that during the three years that follow, funds from unpopular categories have beaten those from popular categories more than 90 percent of the time. They have also outpaced the average domestic-equity fund more than 75 percent of the time. Morningstar introduced the study in 1996, after tracing fund flows back to 1987.

While “unloved” funds vary widely each year, the process Morningstar analysts use to select them never changes. Morningstar suggests investors consider the following ideas to put the findings from the “Unloved Funds Study” to work in their portfolios:

Buy one fund from each of the three most unpopular fund categories.  
Any one category may continue to do poorly, so investors will greatly improve their odds if they diversify.

Be prudent.  
Unpopular categories often experiment in highly volatile markets, so an investor's exposure to these funds should not account for more than 5 percent of a portfolio. This is especially true this year, when all the “unloved” categories are sector funds, which tend to be more volatile than diversified-stock categories.

Use a tax-sheltered account, if possible.  
Purchasing “unloved” funds will increase a portfolio’s turnover, exposing investors to taxable capital gains if the funds perform well.

Be patient.
Investors should be prepared to hold unloved funds for at least three years, because it may take time for them to improve. For example, Latin America was one of the most unpopular fund categories in both 2001 and 2002. In 2003, however, it returned an average of more than 40 percent.

“Finding funds that others shun is a good way to discover attractive investments that are merely out of favor at the moment,” Kinnel said.

About Morningstar, Inc.
Chicago-based Morningstar, Inc. is a global investment research firm, offering an extensive line of print, software, and Internet-based products and services for individuals, financial advisors and institutions. The company is a trusted source for investment information, data, and analysis of stocks, mutual funds, exchange-traded funds, closed-end funds, 529 plans, separate accounts, and variable annuity/life subaccounts.

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