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The Independent Adviser for Vanguard Investors
•
February 2015
•
15
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800-211-7641
owned foreign companies like Nokia
and Sony. And a fund like Global
Equity can invest in the U.S. So the way
I see it, international/global funds are
simply diversified equity funds invest-
ing in another portion of the world
stock market. We shouldn’t exclude
them. (I should mention that I do track
a
U.S.-Only Hot Hands
strategy as
well, and its record is also extremely
good, with an annualized return of
13.7% versus the 11.5% return for the
market. The
U.S.-Only Hot Hands
fund
for 2015 is the same as the overall
Hot
Hands
pick, PRIMECAP Core.)
That’s the background. Now that I
have my universe of funds, I can figure
out 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,
a proxy for the entire stock market,
rather than the average Vanguard fund
or average stock fund.
Measuring performance against the
stock market, rather than the “average”
stock fund, puts even greater pres-
sure on the methodology to generate
decent returns, since the market gener-
ally outperforms the “average” money
manager. Why make my hurdle that
much harder to overcome? Because
I’m not interested in average perfor-
mance—you and I want outstanding
performance. And that’s what we get
with
Hot Hands
.
Strong and Long
Here’s the bottom line: Following
a
Hot Hands
investment strategy at
Vanguard from the end of 1981, when
you would have put your money into
Windsor
, through the end of 2014,
when your money would have been
in Explorer, would have netted you a
total return of 13,591% compared with
a return of 3,513% for Total Stock
Market Index. Those are whopping
numbers, but they simply reflect the
power of compounding over a 30-plus
year period.
Playing the contrarian and buying
the previous year’s worst fund, how-
ever, has proven to be an awful idea.
Since 1981, the strategy would have
netted the investor an index-lagging
1,157% return. (That’s less than one-
tenth the
Hot Hands
gain.)
On an annualized basis, that’s 16.1%
for
Hot Hands
versus 11.5% for Total
Stock Market Index and just 8.0% for
the “dog” fund, contrarian strategy.
What about the performance since I
first told you about the strategy in 1995?
Still quite good:
Hot Hands
has gener-
ated a 14.9% annualized return versus
a 9.9% return for Total Stock Market
Index, and just a 5.3% return for the
“cold” fund through 2014.
Okay. Before we go further, here’s a
warning I feel it’s my duty to give you
just one more time. As I said before,
buying the
Hot Hands
fund doesn’t
guarantee you are going to beat the
market every year. In fact, as the table
on page 14 shows, it missed in 12 of
the past 33 years, for a “miss” rate of
about one-third and a “hit rate” of a
little under two-thirds.
But the “hit” or “miss” rate is not the
point. It’s the accumulation of market-
beating periods that really makes the
difference. Or to put it another way, it’s
the long haul I’m interested in. And over
the long haul, this strategy soars like an
eagle, while other strategies drop like
turkeys. To put this into the perspective
of the fund managers at PRIMECAP
Management, the PRIMECAP team
tends to beat the market a little less
than six out of every 10 months, or
55% of the time—but when they beat,
they really beat, and it’s the wins that
make the PRIMECAP team’s long-term
performance sing. The same can be said
for
Hot Hands
.
Rolling Returns
Another way of assessing the suc-
cess of the
Hot Hands
methodology
is by analyzing rolling returns. As you
know, I don’t believe that one should
measure performance by looking at
a single three-year or 10-year period.
Instead, let’s consider rolling time peri-
ods. As longtime FFSA members have
come to expect, I use rolling time peri-
ods to analyze performance, since they
give you many more periods in which
Hot Hands
Stay Hot
3-year
5-year
10-year
Hot Hands
(buy the best)
Cold Hands (buy the worst)
Total Stock Market
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
20%
22%
24%
to measure returns. Also, they help to
eliminate the bias that creeps in when
only one time period is examined. This
is also why annual reviews of the best
funds over the past 10 years, or over
the past three years, are so shallow
and useless. As I write this, plenty of
“Best of” lists of mutual funds based
on three-year and five-year returns
ending in December 2014 are appear-
ing on newsstands across the country.
These lists have no investment value at
all, but they do sell a lot of advertising.
For the uninitiated, rolling time peri-
ods are sequential periods of, say, 12
months, 36 months or even 60 months.
When applied to the
Hot Hands
strat-
egy, you can think of them as all of
the different one-year, three-year or
five-year periods that an investor might
have followed the strategy. It would
include the three-year period from 1985
through 1987, plus the three years from
1986 through 1988, and up through the
periods ending with 2014.
Putting it to this more extensive
test, does my
Hot Hands
strategy work
over rolling periods? Not only does it
work, but the returns are quite consis-
tent, beating the index over all but one
10-year period since 1981 and beating
the index over 83% of five-year periods
and 71% of all three-year periods.
Over 31 different rolling three-year
periods, the
Hot Hands
strategy pro-
duced an average 16.5% annualized
return, compared with the average
11.4% return for Total Stock Market.
The worst three-year period? A loss
of 12.6% for
Hot Hands
versus a
>
Note: Chart shows average annualized rolling returns from 1981
through 2014.