US Markets

Investors should avoid crowded trades: BofA strategist

Market valuations look fair: Pro

U.S. stocks face near-term headwinds, but investors may be able to outperform by breaking from the pack and avoiding crowded trades, said the head of U.S. equity and quantitative strategy at Bank of America Merrill Lynch.

"This year, oddly enough, one of the best-performing quantitative factors is selling stocks that are most held by mutual funds and buying stocks that are least held by mutual funds," Savita Subramanian told CNBC's "Squawk Box" on Monday.

There are multiple factors at play, she said. To some degree, mutual funds are simply getting it wrong, but it is also harder for stocks to move higher if everyone is already in the trade.

Traders work on the floor of the New York Stock Exchange.
These stocks should be this week's big movers

Subramanian said she believes investors will continue to shift from active to passive funds as they become more price sensitive and wary of paying fees, only to underperform.

Investors should avoid the most overweighted stocks — particularly hyper-growth, high-multiple equities — in the active trading community, she said.

Active funds want to show they held stocks such as Facebook, Amazon, Netflix and Google-parent Alphabet at the end of the year because they were high performers in 2015, she said. With the exception of Facebook, these so-called FANG stocks have turned lower this year.

"I think it's important to be nimble and avoid the crowds. Look for high-quality companies, cash return, dividend growth stories," Subramanian said. "But [mutual fund] ownership might be the most important and under-the-radar attribute that is working this year, that is driving a significant component of returns."

Jim O'Shaughnessy, chairman and CEO of O'Shaughnessy Asset Management, said mutual funds had been "window dressing" by acquiring these momentum stocks.

He instead suggested buying large-cap stocks that are cheap, economically and financially strong, and actively engaged in buying back their shares.

"Fourteen percent of companies that are buying back shares are in the cheapest 5 percent of our value composite, which looks at things like price to sales, price to earnings, et cetera," O'Shaughnessy told "Squawk Box" on Monday.

While it's a good time to take on debt with rates low, companies should not be leveraging up simply to repurchase shares, he said.

According to O'Shaughnessy, large-cap companies returning assets to shareholders through dividends and buybacks had a return of about 3.1 percent between 1964 and 2014 on an annualized basis, while companies issuing shares have lost nearly 4 percent.