(PUB) Investing 2016

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6 • Fund Family Shareholder Association
On an annualized basis, that’s
15.6% for Hot Hands versus 11.1% for
Total Stock Market Index and just 7.5%
for the contrarian “dog” fund strategy.
Now, I’m the first to say that I’ve
never seen a backtest I didn’t like. So,
what about the performance only since I
first told you about the strategy in 1995?
Hot Hands has generated a 13.2% annu-
alized return versus 8.2% for Total Stock
Market Index, and just a 4.1% return for
the “cold” fund through 2015. Not bad.
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 5 shows, it missed in 12 of the
past 34 years, for a “miss” rate of about
one-third.
But the “miss” rate is not the point.
It’s the accumulation of market-beat-
ing periods when the Hot Hands fund
“hits” that really makes the difference.
As I’ve said, it’s the long haul I’m inter-
ested in. And over the long haul, this
strategy soars like an eagle, while other
strategies drop like turkeys.
One of my favorite analogies is
the performance of the fund manag-
ers 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. It’s
those 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 success
of the Hot Hands methodology is by
analyzing rolling returns, something I do
when looking at manager performance.
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 periods
to analyze performance because they give
you many more periods in which to mea-
sure 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
and ETFs based on three-year and five-
year returns ending in December 2015
are appearing on newsstands across the
country and on the web. These lists have
no investment value at all, but they do get
lots of clicks and 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 2015.
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 consistent,
beating the index fund over all but two
10-year periods since 1981, over 80%
of five-year periods and 72% of all
three-year periods.
Over 32 different rolling three-year
periods (calculated using calendar-
year returns), the Hot Hands strategy
produced an average 16.4% annual-
ized return, compared with the average
11.5% return for Total Stock Market.
The worst three-year period? A loss of
12.6% for Hot Hands versus a 14.3%
loss for the index fund. This is par-
ticularly encouraging, since the one
thing you worry about when pursuing
a mechanical strategy like this one is
whether you ever suffer tremendous
losses, something to which other “per-
sistence” strategies are not immune.
Over 30 five-year periods, Hot Hands
returned an average 16.2% per annum
(compared to 10.9% for the index). And
over the 25 ten-year periods, the results
are just as compelling, with an average
annual return of 16.4% (10.4% for the
index) and a worst 10-year annualized
return of 7.7% versus a 0.7% loss for
the market.
Say No to Being Contrary
As the graph above also makes crys-
tal clear, investors who bought into the
contrarian investing theory—buying the
prior year’s worst performer—aren’t
doing themselves any favors. While
there may be a time and place for con-
trarian thinking, this isn’t one of them.
So, how can Vanguard investors like
us make use of this Hot Hands phenom-
enon? First, this isn’t meant to be an all-
or-nothing strategy. Again, I don’t rec-
ommend that you put all of your money
into one Hot Hands fund. We need to
use our heads as well as our spread-
sheets. But the Hot Hands strategy does
lead us to funds that can serve as one
component of a well-rounded portfolio.
As 2016 opens, I haven’t recom-
mended a shift in any Model Portfolio
assets, in part because of the over-
lap between managers at International
Explorer and International Growth,
which is a component of our Models.
Matt Dobbs at International Explorer
(he runs about 70% of the fund) and
Simon Webber (who runs about a third
of International Growth) work together
at Schroder Investment Management.
Yes, International Explorer is focused
on much smaller fare than what you’ll
find at International Growth, and that
might be reason enough to buy some
for our Models. I’ll keep you apprised
as Jeff and I run the numbers and assess
how we want to play it. Obviously,
if we add International Explorer to
the Growth Model Portfolio, we’ll add
a similar position in World ex-U.S.
SmallCap Index to the Growth Index
Model Portfolio. Stay tuned. n
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%
Note: Chart shows average annualized rolling returns from 1981
through 2015.
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