And This Year’s “Hot Hand” Is…

01/08/2009 1:00 pm EST

Focus: FUNDS

Jim Lowell

Partner & Chief Investment Officer, Adviser Investments

Jim Lowell, editor of Fidelity Investor, picks the Fidelity fund that did best last year to participate in his Hot Hands strategy.

“Hot Hands”: the concept couldn’t be simpler. Simply buy whichever fund has performed best in the previous year and hold onto it throughout the upcoming one. The rewards, as demonstrated by over 20 years of data, are stunning, to say the least.

Here are the ground rules for the strategy. First, I looked at all of Fidelity’s retail diversified stock funds for each year between 1983 and 2008. I excluded single-sector (Select, Real Estate, Utilities) funds, and balanced funds (those with significant bond positions). On the international side, I did include the diversified internationals, but (analogous with excluding sector funds) I excluded the geographically nondiversified (regional and single-country) international funds.

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? From the end of 1983, when you would have put your money into Fidelity Magellan (FMAGX), through last year, when you would have had your money in Fidelity Independence (FDFFX), you would have netted a total return of 4,844.5%, while the return for the Standard & Poor’s 500 index would have been 925.1%. On an annualized basis that’s 16.9% for Hot Handsversus 9.8% for the market and just 7.9% for the “worst” fund, contrarian strategy.

Again, buying the Hot Handsfund doesn’t guarantee you are going to beat the index every year. In fact, the Hotfund only beat the index in just 15 out of 25 years (and Hot Independence lagged the market last year—Editor). 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 soars like an eagle, when most other simple strategies fall like turkeys.

This isn’t meant to be an all-or-nothing strategy. I certainly don’t recommend that you put all of your money into one fund and switch it each year. A method that’s generally worked in the past isn’t a sure thing, and with just one holding at a time you’ll see much more risk than you need to. We need to use our heads as well as our computers. But the Hot Handsstrategy leads us to funds which can serve as a niche fund inclusion for a well-rounded portfolio.

This year’s Hot Hand? It’s Fidelity Global Balanced (FGBLX)—managed by Derek Young, a top-ranked top gun if ever there was one!

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