Vanguard’s “Hot Hands” Fund for 2009

02/09/2009 1:00 pm EST

Focus: FUNDS

Daniel Wiener

Editor, The Independent Adviser for Vanguard Investors

Dan Wiener, editor of the Independent Adviser for Vanguard Investors, says buying last year’s top fund produces long-term market-beating returns, and he names 2009’s winner.

My “hot hands” thesis is quite simple: Investors who purchase the prior year's best diversified Vanguard equity fund and hold it for a year and follow this strategy year after year will beat the stock market over time.

I did not say that this strategy beats the market year in and year out. It didn't in 2007 (missing by 0.3%), and it blew it in 2008. It missed in eight of the past 27 years. But that's not the point. It's the accumulation of market-beating periods that really makes the difference.

And I've never advocated that you sink your entire stash into this year's (or any year's) “hot hands” fund. That would fly in the face of the diversified investment approach that I preach to all Vanguard investors.

[But the long-term] performance of the “hot hands investment strategy, as applied to Vanguard's family of funds, is so compelling that it stands conventional wisdom on its head. This strategy doesn't work for all fund families or for all funds, though an analysis by my colleague and partner Jim Lowell, editor of Fidelity Investor ( finds the same pattern among that fund family's offerings.

Vanguard's fund objectives and investment policies are very well-defined. With Vanguard's funds, there's little room for managers to change their tactics. The managers do what they do, and they keep doing it, no matter how the markets change around them.

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 2008. The funds I exclude are sector funds, as well as the 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.

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 (VWNDX), through the end of 2008, when your money would have been in Growth Equity (VGEQX), would have netted you a total return of 5,503% compared with a return of 1,262% for Vanguard Total Stock Market Index (VTSMX).

You and I already owned Vanguard Dividend Growth (VDIGX) before it made the grade and was named 2009 “hot hands” fund. And I expect we'll continue to benefit from Don Kilbride's concentrated portfolio of large caps with sterling balance sheets and a penchant for paying consistent and growing dividends.

Dividends, in fact, were one of the qualities that helped hold the fund up, on a relative basis, in 2008, along with Kilbride's obvious management excellence. I'm looking for good things from the fund in 2009—fingers crossed.

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