(PUB) Investing 2015

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The Independent Adviser for Vanguard Investors • December 2015 • 15 FOR CUSTOMER SERVICE, PLEASE CALL 800-211-7641
MomentumCanBe Profitable
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October Hot Hands
500 Index
Total Stock Market Index
$0
$5000
$10000
$15000
$20000
$25000
periods from October to October has
been a market-beater.
What is October Hot Hands? It’s a
mechanical, momentum-based strategy
of investing with the best-performing
diversified stock funds at Vanguard
over 12-month periods ending each
year on October 31. I’ll explain in
more detail later, but before I get into
the background, let’s get a couple of
updates out of the way.
First off, as I announced last month,
the official October Hot Hands fund
for the period from the end of October
2015 through the end of October 2016
is U.S. Growth.
As for last year’s October Hot Hands
fund, PRIMECAP fared quite nicely
over the 12 months through October
2015, producing a total return of 5.7%
versus 4.3% for Total Stock Market
Index. Investors who couldn’t buy
PRIMECAP because it’s closed and
instead bought my suggested alternative
PRIMECAP Odyssey Growth (POGRX)
did even better, with a gain of 7.0%.
The Vanguard PRIMECAP fund’s
gain just added to the long-term results
for the strategy, which I’ve been track-
ing for 23 years. Over that full peri-
od, October Hot Hands has produced
an annualized return of 13.9% versus
8.3% for 500 Index and 8.4% for Total
Stock Market.
The strategy’s underperformance
from October 2007 through October
2008, the first year after I wrote about
it, hurt the overall numbers consider-
ably, as the graph to the right so clear-
ly illustrates. Over those 12 months,
International Growth (the 2007–2008
October Hot Hands fund) suffered a
47.6% loss, more than 11 percentage
points worse than the U.S. market.
Like my longstanding calendar-year
Hot Hands strategy (which is based on
12-month periods ending December
31), the October Hot Hands strategy
is a momentum-based concept rooted
in research I’ve conducted over many
years. As with any investment strat-
egy based on price and performance
momentum, it can have good periods
and bad periods. The period from the
end of October 2007 to the end of
October 2008 was clearly one of the
bad ones, but on balance, the strategy
has been strong since then, up a total
165.5% versus 149.0% for the market.
The Basics
For those who aren’t familiar with
October Hot Hands, let me back up.
It was in the October 2007 newsletter
issue that I first laid out the strategy.
My research indicated that it might
be as good as, or possibly better than,
the original calendar-year Hot Hands
strategy. Like the original, the October
version identifies the top diversified
equity fund over the prior 12 months
and holds it for one year, then trades to
the next candidate.
While the 12-month period ending
in December remains my choice for
my annual Hot Hands portfolio update
for reasons of simplicity and taxes,
October is a pretty strong candidate for
“best overall.” And I still believe both
of these strategies have merit.
Back-testing shows that using the
Hot Hands methodology in any month
can give you a winner over the market,
confirming my thesis that “hot hands
stay hot,” at least for short periods of
time. What distinguishes one month
from another is how often the strategy
fails to beat the market, as well as the
average level of outperformance over
my testing period. Some months simply
don’t look as good as others when it
comes to implementing a momentum
strategy like this one.
Here’s some of the analysis that
I used to come up with the focus on
October over other months. The first
step was to look at the returns of top-
performing funds (ignoring the sector
funds and international region-specific
index funds) over the 12-month peri-
ods ending in every month of the year.
Next, I calculated the return for each
of these top funds over the ensuing 12
months.
The table above shows the aver-
age annualized market outperformance,
failure rate, and worst year’s perfor-
mance of a Hot Hands strategy using
returns for one-year periods ending in
each of the 12 months of the year. The
data is based on running the test over
the past 23 years.
As you can see, my standard Hot
Hands strategy, which uses calendar-
year performance (see the “December”
row in the table), has both a fairly
strong average outperformance versus
500 Index and a fairly low failure rate,
having failed to beat the market nine
times over the period measured. And at
its worst, it lagged the market by just
11.2%, compared to the 31.7% gap for
the worst single year following a May
strategy.
October looks very strong on most
measures, with a good long-term aver-
age outperformance of 5.6% over 500
Index (third best of all 12 months). It
also has solid consistency, with just
six years in which the strategy fails,
making it the best of the 12 month-
ly strategies on that front. Its worst
performance failure was a 21.0%
23 Years of Hot Hands
by Month
Average
Outperf. vs.
500 Index
Failure
Rate
Worst
12-Month
Gap*
January 1.9% 10 -12.0%
February 0.0% 14 -19.2%
March 1.3% 12 -17.9%
April 6.5% 9 -21.9%
May 4.5% 9 -31.7%
June 4.8% 9 -22.8%
July 4.2% 9 -15.6%
August 2.7% 9 -24.0%
September 0.7% 12 -26.1%
October 5.6% 6 -21.0%
November 4.6% 7 -11.9%
December 7.6% 9 -11.2%
*Difference between each monthly Hot Hands fund’s and
500 Index’s returns.
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