(PUB) Investing 2016

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 >

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

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

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 Note: Chart shows average annualized rolling returns from 1981 through 2015.

6 • Fund Family Shareholder Association

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