Vanguard's Hot Hand for 2010

02/09/2010 1:00 pm EST

Focus: FUNDS

Daniel Wiener

Editor, The Independent Adviser for Vanguard Investors

Daniel Wiener, editor of The Independent Adviser for Vanguard Investors, says the fund that performed best last year can’t be this year’s Hot Hand, and he suggests alternatives.

My Hot Hands thesis and methodology is quite simple: Investment success doesn't disappear with the turn of the calendar. So, investors who purchase the prior year's best diversified Vanguard equity fund and hold it for a year and continue to do so year after year will beat the stock market over time.

Note that I did not say that this strategy beats the market every time, year in and year out. And I've never advocated that you sink your entire stash into this year's (or any year's) Hot Hands fund.

But within the Vanguard family, there is strong evidence that top fund performance persists. That "repeat winners" can stay ahead of the masses. Or as I like to put it: Hot Hands stay hot.

One of the reasons Hot Hands works is that Vanguard's fund objectives and investment policies are very well-defined. One thing Vanguard wants is managers who strictly follow their investment styles and objectives.

So, using the prior year's performance as a guide for selecting Vanguard equity funds is not only useful, but very profitable, because investment styles and markets don't automatically shift once the calendar turns from December to January.

I have looked at the best and worst Vanguard equity funds for each year between 1981 and 2009. The funds I exclude are sector funds such as Energy, Precious Metals & Mining, Health Care, REIT Index, and the old Utilities Income (now Dividend Growth, which I do include), as well as the regional international index funds,since they are what I would consider sector funds. I also exclude balanced funds. However, I do include the diversified internationals in the mix.

Following a Hot Hands investment strategy at Vanguard from the end of 1981, when you would have put your money into Vanguard Windsor (VWNDX), through the end of 2009, when your money would have been in Vanguard Dividend Growth (VDIGX), would have netted you a total return of 6,721% compared with a return of 1,653% for Vanguard Total Stock Market (VTSMX).

On an annualized basis, that's 16.3% for Hot Hands versus 10.8% for Total Stock Market. It's the accumulation of market-beating periods that really makes the difference.

Unfortunately, [last year’s winner] Vanguard Capital Value (VCVLX), is closed. And, while it's too soon to tell, it's possible that with a second manager on the scene the fund may not be the high-octane offering it was in 2009.

In the meantime, my suggestion is to use either Vanguard Selected Value (VASVX) or Vanguard MidCap Value Index (VMVIX) as a substitute. If you own Capital Value, well then, you're already set for what should be another year of profits at the hands of a Hot Hand.

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