Investors looking for winners should consider the losers

NEW YORK -- When it comes to picking winning mutual funds, investors' best bets might actually be found among the losers.

In other words, if you buy the funds nobody wants, in three years you might be happy with your returns. That's the theory behind Morningstar's annual "Unloved Funds" study.

The study found that the funds most shunned by investors in a given year (measured by the amount of money withdrawn from them) will outperform the average stock fund over the next three years in 70 percent of cases, said Morningstar, a Chicago-based research and investor services company.

And, nine times out of 10, the losers from a given year will trend higher than the year's favorite funds.

"It's definitely an argument for being a contrarian investor," said Peter DiTeresa, senior fund analyst at Morningstar. "The funds that are the least loved by investors tend to be the outperformers."

14.3 percent

For proof of the upside potential of "unloved" funds, consider the last three years. The investors who invested in the least favored fund categories in 1999 -- Latin America, Pacific/Asia and natural resources -- were no doubt tempted to sell, particularly during financial crises in Japan and Argentina.

But investors who held onto those funds have fared well since then. Natural resources posted an annualized return of 14.3 percent for 1999 through 2001. Latin America funds climbed 7.7 percent annually, while Pacific/Asia funds advanced 3.9 percent.

The average stock fund gained 4.1 percent over the last three years.

During 2001, the least popular fund categories were communications, hurt by overcapacity in the telecommunications industry; Latin America, suffering from the collapse of Argentina's economy; and diversified Pacific/Asia, still trying to recover from the 1998 economic crisis.

"These funds may look worthy of being unloved, but we're betting on a change," said Gabriel Presler, fund analyst for Morningstar.

Morningstar believes those categories will outpace last year's favorites: mid-cap value, small-cap value and small-cap blend, which combines the value and growth styles. The "value" style, considered less risky than "growth," tends to come into vogue during bearish markets.

Because the Morningstar study gauges popularity by cash flows rather than yearly performance, the implication is that being popular with investors isn't profitable -- at least not forever. The reason, DiTeresa said, comes down to timing. By the time that a particular sector or industry is hot, chances are it's about to flame out.

"Investors are often late to the party, and late to leave," DiTeresa said.

So, the study essentially is an argument against chasing after strong performance. There is no guarantee a fund, or any investment, will repeat the stellar performance of the last quarter, or last year. Technology offers the harshest example, running up by double and triple percentage points in the late 1990s and then crashing just as hard starting in March 2000.

Don't commit everything

Morningstar recommends that investors who want to deploy the unloved funds strategy commit just a small amount of money.

"This is speculative. You don't want to commit a large amount of your portfolio," DiTeresa said.

But investors will need to invest a small amount in all three of the unloved fund categories, because the study averages their performance.

For example, the unloved fund groups from 1996 were: Pacific/Asia funds, Pacific/Asia ex-Japan funds and communications funds, according to Morningstar. Despite the 1998 Asian financial crisis, the overall group posted a three-year annualized return -- from 1997 through 1999 -- of 9.1 percent, thanks to the communications sector.

"It is not possible to gauge which area will have the greatest success," DiTeresa said.

Investors could choose to use the study, as DiTeresa said he does, to determine which sectors to scale back on -- those that have recently been in favor.

"The inverse is true too," DiTeresa said. "The really loved funds tend to be underperformers over the next few years."