(PUB) Investing 2015

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

HANDS FROM PAGE 1 >

23 Years of Hot Hands by Month Average Outperf. vs. 500 Index Failure Rate

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

Worst 12-Month Gap*

January February

1.9% 10 -12.0% 0.0% 14 -19.2% 1.3% 12 -17.9% 6.5% 9 -21.9% 4.5% 9 -31.7% 4.8% 9 -22.8% 4.2% 9 -15.6% 2.7% 9 -24.0% 0.7% 12 -26.1% 5.6% 6 -21.0% 4.6% 7 -11.9%

March

April May June July

August

September

October

November December

7.6% 9 -11.2% *Difference between each monthly Hot Hands fund’s and 500 Index’s returns.

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% >

MomentumCanBe Profitable

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October Hot Hands 500 Index Total Stock Market Index

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The Independent Adviser for Vanguard Investors • December 2015 • 15

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