(02/06/13) 8 Unloved Funds to Consider

Katie Reichart of Morningstar shows how investing contrary to market sentiment can pay off in the long run.

Each year we look at the equity categories that have experienced the greatest outflows and inflows to gauge which areas of the market are unloved or overheated.

The idea is to use fund flows as a contrarian indicator, buying into categories that have seen investors leaving in droves while trimming exposure to those that have experienced a lot of interest. We have tracked this strategy since the early 1990s, and this research indicates that holding funds in the unpopular categories for at least three to five years is an effective approach that yields strong results.

Using fund flows data for the year to date through November (the most recent available), the most popular equity categories in 2012 were diversified emerging markets (inflows of $20.6 billion), foreign large-value (inflows of $5.3 billion), and real estate (inflows of $3.8 billion).

Those looking across asset classes might want to be cautious about sending new money to intermediate-term bond (inflows of $104.9 billion), short-term bond (inflows of $31.7 billion), and high-yield bond (inflows of $24.5 billion), particularly as interest rates have nowhere to go but up.

The most unloved equity categories are also the most unpopular overall: large-growth (outflows of $34 billion), large-value (outflows of $19.7 billion), and mid-growth (outflows of $9.1 billion). These categories have seen outflows despite posting double-digit gains through mid-December.

The money leaving these categories reflects a broader trend of investors fleeing equity funds while piling into fixed-income offerings and passive exchange traded funds. Some of these categories have endured outflows for a while: Large-growth has had annual net outflows since 2004, large-value since 2007, and mid-growth since 2008.

Below, we’ll look at some fund picks in these categories that could serve as good long-term holdings.

Harbor Capital Appreciation (HACAX) is a reliable large-growth option. Longtime manager Sig Segalas and team have produced strong long-term results by focusing on steady blue chips and more aggressive names whose sales growth is growing faster than the S&P 500. Over time, it has held up well in market downturns.

Investors looking for higher growth might instead opt for Primecap Odyssey Growth (POGRX) or Primecap Odyssey Stock (POSKX). These Gold-rated funds often invest in small- and mid-cap stocks and make sector bets, so it can look out of sync from peers at times, but both have stellar long-term records.

Vanguard Growth Index (VIGAX) is a low-cost, passive way to gain access to large-growth stocks. A recent change in index (from the MSCI US Prime Market Growth Index to the CRSP US Large Cap Growth Index) means there could even be more cost savings for investors down the road.

On the large-value side, Sound Shore (SSHFX) is a good choice. Despite a middling three-year record, it has generated an enviable record under its management team, which has been in place for more than 25 years. Dodge & Cox Stock (DODGX) is also proving it’s worth sticking with; after its financial stake hurt results in 2011, it was back in top form in 2012.

Mid-growth investors might opt for Gold-rated Westport (WPFRX), whose longtime manager has excelled with a low-turnover, high-quality approach that’s made the fund less volatile than its peers.

Silver-rated Champlain Mid Cap’s (CIPMX) record dates back only to 2008, but Scott Brayman and team have used the same strategy that’s worked well at Champlain Small Company (CIPSX) and previously at Sentinel Small Company (SAGWX). Their cautious, valuation-driven approach won’t do well in huge rallies, but the fund has held up better than peers in down markets.