Mentioned In This Article

During a recent visit to the Standard & Poor’s offices on Water Street in New York City, S&P’s mutual fund analyst presented an alternative approach to Morningstar’s “Buy the Unloved” fund strategy. “Don’t just buy large-cap growth because it did badly last year (2010); buy large-cap funds that have strong fundamentals,” said Todd Rosenbluth, a mutual fund analyst with S&P Equity Research.

Morningstar has long stood by its “Buy the Unloved” strategy, which has been to invest in mutual funds from equity classes that have seen the most outflows in the last 12 months. At the moment, that would include large-cap growth and large-cap value funds, which have seen outflows of $43.5 billion and $12.5 billion in 2010, respectively. While it all depends on the individual investor situation, these areas are something to think about if the investor is more inclined to be a contrarian, said Kevin McDevitt, Morningstar analyst. (See also our article about buying good funds experiencing cash outflows.)

“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,” said Russel Kinnel, director of mutual fund research with Morningstar, in a commentary.

But according to the S&P, the question isn’t “Should large-cap funds outperform because of a reversion?” But rather, “Will the stocks that are in these portfolios outperform?” said Rosenbluth.

Some large-cap funds will do well relative to the peer group; others won’t. When S&P ranks funds, it doesn’t only look at performance. The analysts also consider track record, whether the fund is inexpensive or not, and what the underlying stocks are. For example, S&P’s equity analysts have strong buy recommendations for Apple and Hewlett-Packard, but they have a negative recommendation for Dell. When considering whether to invest in a fund, Rosenbluth recommends looking at the top 10 holdings and making sure they are high quality, attractive securities.

If we put S&P’s approach to work, one attractive large-cap fund would be the American Century Growth Fund (TWCGX). According to S&P’s Rosenbluth, this fund has an excellent track record, outperforming the benchmark on a one-year, three-year, five-year, and 10-year basis though November 2010. It’s also inexpensive, with an expense ratio of 1 percent, compared to the average of 1.4 percent. The fund’s top holdings include Apple, Exxon Mobil, Coca-Cola and Oracle, stocks that S&P analysts feel are attractive and inexpensive.

Alternatively, an unattractive fund would be the CGM Focus Fund (CGMFX), according to S&P’s methodology. This two-star ranked fund has had the worst performance in 2008 and 2009 in its peer group, Rosenbluth said. It also holds what it considers to be fairly-valued stocks, including Ford, Priceline and Teck Resources.

Rosenbluth said he understands the premise behind “Buy the Unloved,” and he even believes the strategy works in the stock market. But the approach doesn’t work when you’re buying mutual funds, he said.

That said, S&P does expect large-cap stocks to outperform small-cap stocks in 2011, but not because they are unloved. S&P believes the third year of a bull market, which begins in March 2011, is a better time to be in large-cap stocks than small caps because in modest times, large-cap securities have historically outperformed, Rosenbluth said.

To read an article on what funds would work under Morningstar’s approach, click here.