Buying Unloved Funds Could Prove Lucrative

Much like finding a perfect partner, there are hidden investment gems everywhere: you just need to know where to look

Valerio Baselli 14 February, 2019 | 2:27PM
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Valentine's Day Roses

Valentine’s Day is the day to celebrate love, but what about the unloved? Much like finding a perfect partner, there are hidden gems everywhere: you just need to know where to look. The same logic can be applied to investments, specifically to those funds that have not been “loved” by investors for a while.

On the surface, "unloved" funds may seem to be unloved for a reason: a period of underperformance, an out-of-favour investment strategy, challenges to the broader sector, or more appealing options elsewhere. But taking a contrarian approach to fund selection can also yield dividends. Fund flow patterns over the past 25 years tell us that investors tend to buy funds that have performed well recently and sell what hasn't. This pattern can become self-reinforcing. Strong flows drive up stock prices, attracting more return-chasing investors and bidding up prices further.

Just as inflows beget more inflows, outflows beget more outflows. Eventually, popular stocks become too expensive and unpopular ones too cheap, and the process reverses itself. Investors who target the least popular areas of the market benefit when sentiment turns. Of course, outflows don’t make funds themselves any cheaper, but they might indicate which market sectors are unpopular and ready to recover. This strategy, best suited for the periphery of your portfolio, captures that intuition.

For the past 25 years, Morningstar has been testing the results for buying unloved funds, through its Buy the Unloved strategy. This involves investing equal sums in one fund from each of the three equity Morningstar Categories with the largest calendar-year outflows while avoiding those with the heaviest inflows. After three years, sell the stakes and invest the proceeds equally in that year’s unloved categories.

The results from the initial sample of US funds has been stark: the unloved portfolio has beaten the loved one, our three most “loved” categories in terms of inflows of the previous year, by more than 5.8 percentage points annually from January 1994 through the end of 2018. In looking to apply this to the European funds market, Global Equity Income, UK Equity Income, and European Large-Cap Blended Equity sectors were the most unloved Morningstar equity categories in Europe last year.

Unloved Funds That Could Flourish

Despite this, a number of funds could return to favour if markets re-rate their categories, including:

Global Equity Income: 

Gold-rated Veritas Global Equity Income 

Applies a real return approach, analysing potential investments on an absolute basis rather than relative to an index. Managers aim to identify quality companies that offer durable competitive advantages and strong, sustainable cash flows, and dividends.

Although themes play a role, the managers are not running a thematic portfolio, as ideas also come purely from the bottom up. For example, the sell-off in food & drink names in 2018 created some opportunities to buy into Unilever and Reckitt Benckiser. Veritas has announced that lead manager Charles Richardson will step back from portfolio management activities in 2020 to focus on his role as chairman of Veritas Asset Management.

Silver-rated M&G Global Dividend Fund

The fund’s philosophy is to grow the absolute dividend distributed to investors by investing in stocks that can achieve above average dividend growth. Hence, no-growing high-yielding stocks are typically not found in this 50-name portfolio.

Lead manager Stuart Rhodes applies a bucket structure that divides the portfolio into three core segments of stocks with different characteristics, which helps balance the portfolio, though the fund tends to be less stable than peers. Nevertheless, investors willing to accept this volatility have been served well over a full cycle. The fund ranks in the top decile over the trailing three- and 10-year periods ended December 2018.

UK Equity Income

Silver-rated Threadneedle UK Equity Income Fund 

The fund’s pragmatic approach to income investing and experienced manager inspire confidence that it can continue to reward investors over the long term. The investment approach aims to deliver a combination of capital growth and income, with an emphasis on the former.

Manager Richard Colwell follows a contrarian, bottom-up approach to construct a fairly high-conviction portfolio of 45-60 names. He and the team use a combination of valuation metrics, company management meetings, and macroeconomic research to identify attractive investment ideas. The fund has been a strong long-term performer. From mid-2012 through December 2018, it has comfortably outperformed the benchmark and the typical peer in both absolute and risk-adjusted terms.

Europe Large-Cap Blend Equity

Gold-rated Uni-Global Equities Europe

The rigorous and replicable approach is one of its key strengths. The investment process blends strong quantitative optimisation techniques with fundamental risk assessments to produce a diversified portfolio with low volatility and reduced drawdowns compared with the broad market.

The team is impressive in its efforts to constantly fine-tune the strategy to better identify and control risks and thus sidestep the pitfalls often associated with low volatility strategies. Finally, the fund’s long-term risk-adjusted performance is outstanding, even though the strategy is not designed to outperform each year, as evidenced by the underperformance generally accrued in strong bullish markets.

Silver-rated MFS European Research Fund

Offers a robust, team-based approach which has rewarded investors so far. This fund is focused on bottom-up fundamental research, and MFS is known for the strength of its research culture.

The fund has typically exhibited a quality bias as the team seeks companies with above-average sustainable growth, high-quality returns, and sound management. The portfolio is constructed using the best ideas from the analysts, and each analyst is given the freedom to use his or her own models for research.

 

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Valerio Baselli

Valerio Baselli  is an Editor at Morningstar Italy.