Tuesday, November 13, 2012

Best Mutual Fund Investing Strategy

Fund industry dogma dictates that past performance is not a guarantee, nor a predictor of future results. On the face of it, this sounds reasonable. But in 1995, I discovered that one momentum strategy, applied correctly, CAN predict future results. I call it "Hot Hands."

My Hot Hands thesis is simple. Investors who purchase the prior year’s best-diversified Vanguard equity fund and hold it for a year, and follow this strategy year after year, will beat the stock market over time. It’s that simple.

But how does this work, and why?

One of the reasons that Hot Hands works at Vanguard and not within the greater universe of funds is that Vanguard’s fund objectives and investment policies are very well-defined (see also, “How to Increase Profits with Vanguard Mutual Funds“). With Vanguard’s funds, there’s little room for managers to change their tactics. The managers do what they do, and they keep doing it, no matter how the markets change around them. If they don’t, then generally Vanguard fires them. One thing Vanguard wants is managers who strictly follow their investment styles and objectives. So using the prior year’s performance as a guide for selecting Vanguard equity funds is not only useful, but very profitable (see also, “Vanguard Funds: Fear, Fodder, Facts and Financials“).

That’s good, because in most markets once an investment trend takes hold, it tends to keep going for a while before another trend takes its place. So, if a fund manager’s strategy is “hot,” then it tends to stay “hot” for a while. In my research I have looked at the best and worst diversified equity funds at Vanguard for each year between 1981 and 2007. I also exclude any funds that don’t meet my diversification criteria.

Vanguard’s Hot Hand Fund

From this universe of funds, I can then determine which is the “hot” fund each year, follow it in the next year and compare its return with the market benchmark. When I make those comparisons, I measure rolling three-year, five-year and 10-year returns for the Hot Hands fund against Total Stock Market Index (VTSMX) a proxy for the entire stock market.

Here’s the bottom line: Following a Hot Hands investment strategy at Vanguard from the end of 1981 through the end of 2007 would have netted you a total return of 10,647% compared with a return of 2,064% for Total Stock Market. That’s better than 5–to-1.

Now, some investment pundits think buying a year’s worst fund is a good contrarian strategy. Don’t bet on it. I looked at how this would play out at Vanguard and, without mincing words, it’s an awful idea. Since 1981, the strategy would have netted the “dog-buying” contrarian investor a return that was less than one half that of the overall market.

On an compounded, annualized basis, that’s 19.7% for Hot Hands versus 12.6% for Total Stock Market, and just 9.0% for the “dog” fund, contrarian strategy.

Over 24 rolling three-year periods, the Hot Hands strategy returned an average 20.2% annualized return compared with a 12.8% return for Total Stock Market. The worst three-year period was a gain of 6.6% for Hot Hands versus a 14.3% loss for the index. In fact, the worst single year for the Vanguard Hot Hands investor was 2002, when Selected Value (VASVX) lost 9.8%, which was less than half the market’s decline. This is particularly encouraging, since the one thing you worry about when pursuing a mechanical strategy like this one is whether you will ever suffer tremendous losses.

Even better, the Hot Hands strategy has a 100% record of beating the index over 10- and five-year periods, and beats the index 88% of the time over rolling three-year periods.

But note that I didn’t say that this strategy beats the market every year. It missed by 0.3% in 2007, and it has missed in other years as well. It’s not a lock on doubling your money. And I’ve never advocated that you sink your entire stash into any Hot Hands fund. That would fly in the face of the diversified investment approach that I preach to all investors. But I believe growth-oriented investors can improve their total portfolio’s performance by making sure that a portion of their money is following the Hot Hands strategy.

It’s also worth noting that this strategy doesn’t work for all fund families or for all funds, though my colleague Jim Lowell, editor of Fidelity Investor, has found the same pattern among that fund family’s offerings. But for the fund families it does work for, this strategy soars like an eagle, while others drop like turkeys.

Dan Wiener names the names of the Hot Hands funds, in his monthly newsletter, The Independent Adviser for Vanguard Investors, where he helps his subscribers make more than 144% more than the average Vanguard investor.   And with his risk-free money-back guarantee, you have nothing to lose, but a ton to gain. Get started today!

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