(PUB) Investing 2016

and markets don’t automatically shift once the calendar turns from December to January. And ignoring hot strate- gies, or going with the “dogs,” as some investment advisers who use a contrar- ian approach like to suggest, can lead Vanguard investors to market-lagging and even negative returns. Dogs are dogs for a reason. They make great pets, but lousy bets. But, let’s get back to the Hot Hands winners. Here are the ground rules for the strategy as I originally set them out in 1995 when I conducted the first analysis (and when we owned PRIMECAP , 1994’s best fund, in our Model Portfolios ). I’ve continued to follow these rules and have updated my research as new funds have been introduced. I have looked at the best and worst Vanguard equity funds for each year between 1981 and 2015. The funds I exclude are sector funds, such as Energy , Precious Metals & Mining , Health Care , both of the REIT funds and the old Utilities Income (now Dividend Growth , which I do include), as well as the regional international index funds, Emerging Markets Stock Index , European Index and Pacific Index , since they are what I would consider sector funds. I’ve also exclud- ed the actively managed Emerging Markets Select Stock . Plus, I don’t consider balanced funds and Market Neutral , which (besides having a pro- hibitive investment minimum) is really a hybrid fund. However, I do include the diversi- fied internationals in the mix. You see, domestic funds have the right to invest overseas, and, indeed, funds like U.S. Growth or PRIMECAP can and have 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 13.3% versus the 11.1% return for the market.

Long-Term Performance Hot Hands fund

Total return

Following year

Total Stock Market*

21.7% 18.2% -3.3% 28.0% 56.7% 12.5% 18.8% 15.0% 4.6% 46.8% 13.0% 13.5% 0.8% 35.5% 24.2% 22.0% 25.4% 28.8% 18.0% 13.7% -9.8% 44.5% 31.8% 20.5% 30.3% 5.2% -47.9% 21.7% 20.2% -1.6% 13.5% 43.9% 3.9%

1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Windsor

16.8% 46.4% 43.0% 19.4% 57.0% 56.7% 24.0% 28.7% 37.7% 4.6% 55.9% 19.0% 44.7% 11.4% 38.8% 26.4% 36.8% 42.2% 97.8% 21.9% 15.0% -5.6% 57.4% 31.8% 20.5% 30.3% 22.5% -25.6% 81.5% 30.7% 10.6% 22.3% 44.4% 19.3%

18.7% 23.5% 3.0% 32.6% 16.1% 2.3% 17.9% 29.2% -6.2% 34.2% 9.0% 10.6% -0.2% 35.8% 21.0% 31.0% 23.3% 23.8% -10.6% -11.0% -21.0% 31.4% 12.5% 6.0% 15.5% 5.5% -37.0% 28.7% 17.1% 1.0% 16.3% 33.3% 12.4% 0.3%

SmallCap Index

International Growth

Windsor

International Growth International Growth International Value

Windsor

U.S. Growth U.S. Growth

Explorer

Convertible Securities International Growth

PRIMECAP Windsor II Windsor PRIMECAP

Growth Index

Capital Opportunity SmallCap Value Index

Selected Value Global Equity

International Explorer International Explorer International Explorer International Explorer Growth Equity Dividend Growth Capital Value Equity Income Capital Value SmallCap Growth Index PRIMECAP Core International Explorer Explorer

0.9%

8.6% — *Figures for Total Stock Market Index prior to the fund’s inception are for the Wilshire 5000 index. Bold figures indicate superior perfor- mance in the given year. —

mance—you and I want outstanding performance. And that’s what we get with Hot Hands . Long-Term Heat 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 2015, when your money would have been in PRIMECAP Core, would have netted you a total return of 13,720% compared with a return of 3,523% for Total Stock Market Index. Those are whopping num- bers, but they simply reflect the power of compounding over a 34-plus year period. Playing the contrarian and buying the previous year’s worst fund, how- ever, has proven to be an awful idea. Since 1981, the strategy would have netted the investor an index-lagging 1,076% return. (That’s less than one- tenth the Hot Hands gain.) >

The U.S.-Only Hot Hands fund for 2015 is the same as the October Hot Hands pick, U.S. Growth.) That’s the background. Now that I have my universe of funds, I can determine 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 the 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-

The Independent Adviser for Vanguard Investors • February 2016 • 5

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