(PUB) Investing 2015

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

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-

Hot Hands Stay Hot

10% 12% 14% 16% 18% 20% 22% 24%

Hot Hands (buy the best) Cold Hands (buy the worst) Total Stock Market

0% 2% 4% 6% 8%

3-year

5-year

10-year

Note: Chart shows average annualized rolling returns from 1981 through 2014.

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 >

The Independent Adviser for Vanguard Investors • February 2015 • 15

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