It’s IRA time, with people opening individual retirement accounts after doing their tax returns and then fretting over where to invest the new money. Some labor over the decision, figuring there is one right fund. Yet, if you already have a balanced mixture that invests in the total U.S. stock market, a diversified international fund and a bond fund, and want to add some spice, you might want to pick a fund that disgusts you.
Yes, you read that right. I’m talking about picking an ugly fund, one that people haven’t wanted to touch for the past three years.
Typically, people figure the way to make money is to go with the fund that’s been bestowing wealth and winning the hearts of investors lately.
But the truth is that stocks and funds run in cycles. They are sweet for a while, then turn ugly, and eventually become darlings again after no one has wanted to touch them.
So a strategy suggested by Morningstar since 1994 is to choose what it calls “the unloved.” That means picking a type of fund that has been snubbed in the marketplace.
I’m not talking about a fund with a lousy manager. Those funds tend to stay lousy. And I’m not talking about a fund that has such high fees that investors never make as much money in them as they would in a cheaper fund.
Rather, I am talking about a fund that invests in a certain category, one most people consider unpopular at the time. In the mid-’90s, such a category was gold. When Morningstar suggested buying the unloved precious metal funds of 1995, the idea sounded ridiculous. No one wanted to touch the stuff. For years, gold had been a loser. Then in 2000, gold started to win favor with investors, and by 2008 it was clearly becoming beloved. A few years later, it was the darling of investors, and the SPDR Gold Trust fund became one of the most popular funds sold.
As Morningstar has studied its “unloved” strategy, however, it has found that unpopular funds can be detested for a long time, sometimes years. So the firm’s analysts suggest that people buy only a little and that they simultaneously invest in the three most unpopular categories from the past three years. Together, each year’s three unloved funds have gained, on average, 8.4 percent a year from 1993 through 2012, Morningstar’s Katie Rushkewicz Reichart said. That compares with a 6.9 percent average annual gain in the MSCI World Index, an index that reflects the stocks of the world in aggregate.
Note that you don’t pick the trio based on how awful their returns have been for three years. Rather, you pick them based on how much people have come to detest them, indicated by investors leaving in droves.
So the unloved group that you would buy this year would include a large-cap growth fund, or a fund that picks stocks of large companies with fast growth — companies like Apple — and a large-cap value fund, or a fund that picks large companies that are cheaply priced. In addition, you would pick a large-cap blend fund, or a fund that picks a variety of large companies, some fast growers and some that are more sluggish, but all with cheap stock prices.
Investors holding such funds did well in 2012, earning double-digit gains. But under the strategy, that’s not why you buy them. Instead, you select the three because investors haven’t wanted them. Last year, investors yanked $39.5 billion from large growth, $16 billion from large value and $14.4 billion from blended funds.
And in a sign that investors really dislike these funds, they have been pulling money out of the large-cap growth funds since 2004 and the large value funds since 2007. Instead, investors have loved bond funds, which were a safe haven in the financial crisis but are limited now by yields that don’t cover inflation and which will lose money if interest rates rise.
Rushkewicz Reichart suggests these unloved-type funds: LKCM Equity, Vanguard Growth Index, Dodge & Cox Stock and Vanguard Dividend Growth.
She urged caution about depending heavily on bond funds: intermediate bond funds, short-term bond funds and high-yield bond funds. While they have been winners in the recent past, loved funds don’t stay loved forever.
Morningstar analyst Greg Carlson suggests caution involving 2012’s most popular funds: Vanguard Short-Term Investment Grade, Ivy High Income (high-yield bond fund), Oppenheimer Developing Markets (emerging-market fund) and Vanguard REIT Index (real estate fund).