(PUB) Investing 2015

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 >

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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 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 or 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.

The Independent Adviser for Vanguard Investors • February 2015 • 13

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