Go Contrarian to Avoid Correlation

Focus: FUNDS

The odds are still stacked against individual investors, but if you're willing to look outside the world of income stocks, contrarian funds may be a good investment, writes Kevin McDevitt of Morningstar FundInvestor.

With money rushing into index funds, active contrarians may offer a way to cut risk.

These funds may be of special interest to risk-averse investors who want equity exposure but are concerned about market risk. That’s understandable, since the whole notion of market risk has been turned upside down in recent years, not just by frightful headlines, but also by the headlong rush into passively managed index vehicles, open-end funds, and ETFs alike.

Nearly $575 billion, or more than 20% of beginning assets, left actively managed US stock funds from May 2006 through August 2012. Over that same span, passively managed vehicles collected $350 billion. As a result, passive fund market share has roughly doubled over the past ten years to 33% of US stock fund assets.

The problem with the increasing popularity of index funds is that it could diminish some of their virtues. To be sure, the case for index funds is very compelling. They offer low costs, broad diversification, and generally competitive risk-adjusted returns versus category peers without much manager risk (that is, the risk that a fund manager underperforms his index).

But flows into passively managed funds have arguably diminished the benefits of diversification and increased risk in equity markets. In a paper published this spring in the Financial Analysts Journal, Rodney Sullivan at the CFA Institute and Morningstar Investment Management’s James Xiong argue that ETF flows in particular have contributed to increased correlations among stocks, as they increasingly trade as part of index baskets rather than individually.

They estimate that ETF trading now accounts for roughly one-third of all trading in the US.