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A strategy that’s handily beat the market over 27 years points to a small and obscure fund, writes Jim Lowell in Fidelity Investor.

Hot Hands” is a simple strategy: Buy whichever fund has performed best in the previous year and hold onto it throughout the upcoming one. The rewards, as demonstrated by 27 years of data (see table below) are stunning, to say the least.

It is interesting to see how a simple system, and you can’t get much simpler than “buy last year’s winner”, can beat the market and most professional managers. Using the prior year’s performance as a guide for selecting Fidelity funds is highly profitable. And ignoring it, or going with the “dogs” as some investment advisers who use a contrarian approach like to suggest, can lead to market-lagging results.

The methodology isn’t complicated. There’s no magic black box. But does it work? The following table shows how our Hot Hands investment strategy at Fidelity fared.

Beating the Market by a Touchdown
From the end of 1983, when you would have put your money into Fidelity Magellan (FMAGX), through the end of last year, when you would have had your money in Fidelity Latin America (FLATX), you would have netted a total return of 6,957%, while the return for S&P 500 would have been 1,391.8%.

On an annualized basis that’s 17.1% for Hot Hands versus 10.5% for the market and just 9.1% for the “worst” fund, contrarian strategy.

Buying the Hot Hands fund doesn’t guarantee you are going to beat the index every year. In fact, the Hot fund only beat the index in 16 out of 27 years. But that’s not the point. It’s the accumulation of market-beating returns that really makes the difference. (To put it another way, the good years were better than the bad years were bad.) And over the long haul this strategy has delivered hedge fund-like gains without any of the hedge fund snafus.

And Now for the 2011 Hot Hand
It’s Stock Selector Small Cap (FDSCX). While this fund has been around since 1993, it has undergone numerous manager changes, a name change (formerly Small Cap Independence), and also a few key objective and strategy changes.

Currently its team-managed crew looks for small-caps domestically and globally. With fewer than 200 issues, it’s a concentrated portfolio and, perhaps because of the various changes the fund has seen over the years, it’s off the grid of most investors.

The $1.4 billion fund has a 20% allocation to technology, 20% in financials, 14% in consumer discretionary and industrials, and 12% in health care.

This strategy boasts a similarly impressive record when applied to Vanguard funds, and recently led Daniel Wiener to another red-hot small-cap offering. Richard Lehmann recently profiled two low-cost small-cap ETFs that also enjoyed a banner year—Editor.]

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