(PUB) Investing 2015

The Independent Adviser for Vanguard Investors

•

February 2015

•

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In fact, all of the funds I said I pre-

ferred outperformed Explorer’s 3.9%

gain in 2014, with returns of 11.8% for

Dividend Growth

, 18.9% for

Capital

Opportunity

and 6.4% for

Selected

Value

To say it was a disappointing year

for the

Hot Hands

strategy would be an

understatement. But this doesn’t sway

my belief that the strategy works if you

give it time, and use your head as well.

The 2015

Hot Hands

fund,

PRIMECAP

Core

, which gained 19.3% in 2014,

is run by the best management team

Vanguard has to offer. I would say that

PRIMECAP Management’s hand has

been hot for decades, actually, and as

PRIMECAP Core and its older sibling

Capital Opportunity are already in our

three active-fund

Model Portfolios

, those

who’ve been following my advice don’t

need to make any big portfolio moves.

Back to the Future

I realize that many FFSA members

already know what a

Hot Hands

fund

is, and I also know a lot of you have

earned very nice returns following this

strategy. But because we are constant-

ly gaining new FFSA members, and

because there apparently are a few vet-

erans who like a regular update, I think

it’s important to review the

Hot Hands

history and strategy.

First, I’ll walk you through the meth-

odology I use and show you the results

from both back-testing and in real time.

You don’t need a computer or a calcula-

tor. You don’t need a spreadsheet. Jeff

and I have done all the work for you.

The

Hot Hands

thesis is quite sim-

ple: Investors who purchase the prior

year’s best diversified Vanguard equity

fund and hold it for a year, and continue

with that pattern year after year, will

beat the stock market over time. A sim-

pler way of saying this might be that

investment success doesn’t disappear

with the turn of the calendar.

That’s it. No fancy talk. No mumbo

jumbo. No candlestick charts, tea

leaves, patterns in the coffee grounds

or astrological observations. It’s perfor-

mance, plain and simple.

Now, a quick comment. You may

recall that last month I warned that

investors shouldn’t fall prey to some-

thing called “recency bias,” which

is the tendency to project into the

future the experience of the recent

past. Indeed, one could look at the

Hot Hands

momentum strategy as a

formulaic example of recency bias. I’ll

go with that. But I’ll also note that (1)

it’s a mechanical system with strong

back-testing that doesn’t require you

to make a qualitative judgment to fol-

low, and (2) it’s not something I would

recommend you apply to your entire

investment portfolio, and I never have.

And please note that in my explana-

tion of the methodology, I didn’t say,

and never have said, that this strategy

beats the market every time, year in

and year out. It didn’t in 2007 (missing

by 0.3%); it didn’t in 2009 (a miss of

7.0%); and to my chagrin, we missed

in 2011 (by 2.6%), 2012 (by 2.8%) and

2014 (by 8.5%).

Plus,

Hot Hands

was decidedly cold

in 2008 if you didn’t take my advice

(my “qualitative” advice) to avoid

Growth Equity

. Still, I’ll count that

turkey’s 47.9% loss in the record—

warts and all. All the results, by the

way, can be found in a table on page 14.

So let me repeat: I am not telling

you this strategy is a lock on doubling

or tripling your money every year. And

I’ve never advocated that you sink your

entire stash into this year’s (or any

year’s)

Hot Hands

fund. That would be

foolish and would fly in the face of the

diversified investment approach that I

preach to all Vanguard investors.

While I’ve often allocated a portion

of my

Growth

Model Portfolio

to the

Hot Hands

fund, I don’t always do

so, and I certainly don’t go overboard

when I do. My feeling, though, is that

growth-oriented investors (particularly

those who, like me, benchmark their

overall performance against the stock

market) can often improve their total

portfolio’s performance by making sure

that at least a portion of their money is

following the

Hot Hands

strategy.

The first question that newbies to

this strategy always ask is, “Why are

Hot Hands

hot?” Well, not all of them

are, as some recent years have shown.

So you can stop there if you like. But if

you read on, I’ll show you that within

the Vanguard family, there is strong

evidence that top fund performance

persists. That “repeat winners” can stay

ahead of the masses. Or as I like to put

it:

Hot Hands stay hot.

This cuts against the grain of fund

industry dogma that past performance

is neither a guarantee nor a predictor

of future results. On the face of it, this

sounds reasonable. But momentum,

which is what this essentially is, has

FROM THE FEB. 2014 ISSUE:

For 2014, I haven’t recommended a shift of

any

Model Portfolio

assets into

Explorer

for a couple of reasons. First, small-cap

stocks of all stripes rallied hard in 2013, and

by most of the measures that I use to look

at relative valuations, small stocks are the

most expensive in the market right now. I

think larger stocks, like those Don Kilbride

buys for

Dividend Growth

, are better val-

ues currently. But I also have a problem with

the massive number of portfolio managers

running Explorer’s portfolio. Currently there

are seven different investment manage-

ment companies and 13 individuals named

as portfolio managers on the fund. That’s

ridiculous. Yes, Explorer’s 44.4% gain out-

paced

SmallCap Growth Index

’s 38.0%

rise by a good margin. But a good portion of

that return may have been due to just two

of the managers on the fund: The folks at

Granahan Investment Management, whose

solo Vanguard charge, a foreign small-cap

fund for non-U.S. investors called U.S.

Discoveries, rose more than 56% in 2013;

and Wellington’s Ken Abrams, who also

scored returns in the same ballpark for a

Wellington-run small-cap fund.

Explorer’s other managers simply weren’t

up to par. And, let’s not forget that the fund’s

long-term performance under its vaunted

multimanager system has been less than

stellar, no matter how Vanguard likes to spin

the tale. I’ll take what few small-caps I can

get through funds like

Capital Opportunity

Selected Value

for the moment. If the

markets correct and small-caps become a

screaming buy, then maybe Explorer’s worth a

trade. But I’m not putting money there now.

FIZZLE

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