(PUB) Investing 2016

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4 • Fund Family Shareholder Association
From the many emails I receive and
comments posted on our members-
only conversation boards, I am confi-
dent 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 constantly gaining
new FFSA members, and because there
apparently are a few veterans who like
a regular update, I think it’s important
to review the Hot Hands history and
strategy at least once a year.
With that said, first, I’ll walk you
through the methodology I use and
show you the results from both back-
testing and in real time. You don’t need
a computer or a calculator. You don’t
need a spreadsheet. Jeff and I have done
all the work for you.
The Hot Hands thesis is quite simple:
Investors who purchase the prior year’s
best diversified Vanguard stock fund
and hold it for a year, and continue with
that pattern year after year, will beat the
stock market over time. Another way to
look at this would be to understand 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, you’ve often heard me say
that investors need to be cautious of
something called “recency bias,” which
is the tendency to believe that what-
ever’s worked most recently will con-
tinue to work into the future. And I still
believe that wholeheartedly. But the
Hot Hands methodology is a mechani-
cal system with strong backtesting that
doesn’t require you to make a qualita-
tive judgment to follow or not follow a
particular fund, manager or investment
strategy. Plus, and this is important,
Hot Hands is not something I would
recommend you apply to your entire
investment portfolio. I never have, and
I never would.
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 the now-
defunct 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 5.
So let me repeat: I am not telling you
this strategy is a lock on doubling or
tripling the market’s return 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.
Hot or Not
The first question that investors new
to this strategy always ask is, “Why are
Hot Hands hot?” Well, not all of them
are, as some recent years have shown.
Full stop. 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 win-
ners” 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 strategy is ground-
ed in, has many adherents—even at
Vanguard.
Consider that Vanguard has often
handed assets over to quantitative man-
agers who, in part, rely on past per-
formance to choose stocks for their
portfolios. To name a few, just look
at the momentum strategies employed
by Acadian Asset Management
( Global Equity) or Vanguard’s Equity
Investment Group (Strategic Equity,
Strategic SmallCap Equity, U.S.
Value and various other sub-portfolios)
or the managers at Growth & Income.
As I’ve said, the Hot Hands approach
doesn’t work each and every year, and
some “persistence of performance”
investors have had their heads handed
to them chasing a variant of the strategy.
One fund guru who used to pursue the
“persistence” theory gave it up because
it didn’t work within the huge sea of
funds that he was tracking, then came
back to it when results turned around.
But after 2007, 2008 and 2009, he
began to question whether the theory
still held true. It failed to beat the market
in 2010, and as far as I can tell, the strat-
egy has been abandoned completely.
Plus, I think it’s worth noting that
this persistence tracker set himself up
against a rather easy benchmark: The
average equity fund. I consider the
average fund a low hurdle that doesn’t
hold a candle to the market benchmark
I use.
My Vanguard-focused Hot Hands is
better.
One of the reasons the Hot Hands
system works over the long run at
Vanguard and not within the greater
universe of funds is that Vanguard’s
fund objectives and investment policies
are very well-defined. With Vanguard’s
funds, there’s little room for manag-
ers to change their tactics. (Though as
we’ve seen time and time again, there
is room for managers to fail, and to
change.) The managers do what they
do, and they keep doing it, no matter
how the markets move around them.
If they don’t, then generally Vanguard
fires them. One thing Vanguard seeks
when hiring outside managers is those
who’ll strictly follow their investment
styles and objectives.
So using the prior year’s perfor-
mance as a guide for selectingVanguard
stock funds is not only useful, but very
profitable, because investment styles
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