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Morningstar: Consider the Unloved of 2011

Year to date through November 2011, retail investors have redeemed $61.6 billion from large-cap equity mutual funds, $11.2 billion from mid-cap growth funds, $13.4 billion from world stock funds, and $15.7 billion from municipal bond funds, according to Morningstar data. But these funds—the most unloved of 2011—are exactly what investors should be looking for in 2012, Morningstar says.

During a recent Morningstar webinar, Director of Research Russel Kinnel said “buying the unloved” is a strategy that often works, especially because it means heading away from overhyped asset classes toward those that are cheaper. The fund tracker suggests that investors buy fund categories that are suffering outflows. Often such unloved funds are close to hitting a trough and about to enjoy a revival.

“The premise behind buying the unloved is simple: Fund flows chase returns, and the combination of flows and strong past returns are good indicators that an asset class is overvalued,” Kinnel said, in a commentary.

Because categories don’t always rebound immediately, Morningstar uses a diversified approach. To implement the strategy, you invest in the three equity fund categories that recorded the most redemptions during the preceding 12 months. (For 2011, that would be large-cap, mid-cap and world stock funds.) Then you hold the funds for three years. In comparison, the loved funds for 2011 included emerging markets, world allocation and commodities funds.

As far as growth funds, Kinnel recommended the PRIMECAP Odyssey Growth Fund (ticker: POGRX) and the Sequoia Fund (ticker: SEQUX), which uses Warren Buffett’s investment strategy of buying good businesses at reasonable prices.

While they don’t fit into an asset allocation bucket, world stock funds give managers the flexibility to go wherever they find the best investment. The Artisan Global Value Investor Fund (ticker: ARTGX) is one world stock fund Kinnel recommends because the manager is a stickler for buying companies with strong balance sheets.

In addition to the equity funds, municipal bond funds also saw significant outflows in 2011, and this was another asset class Kinnel said investors should consider. Municipal bond funds have had a nice rally, he said, and still offer pretty good yields, particularly for investors in the highest tax bracket. In addition, defaults are down this year, despite analyst Meredith Whitney’s doomsday prediction about municipal defaults. According to Standard & Poor’s data, municipal defaults in 2011 were down 69 percent from 2010. Monetary defaults in the S&P Municipal Index totaled about $750 million in 2011, compared to defaults of $2.4 billion in 2010. “The sky is not falling,” Kinnel said.

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