Go With Vanguard's Hot Hand? Maybe

02/14/2008 12:00 am EST

Focus: FUNDS

Daniel Wiener

Editor, The Independent Adviser for Vanguard Investors

Dan Wiener, editor of the Independent Adviser for Vanguard Investors, says it’s usually profitable to go with Vanguard’s best performing fund—but this year there are caveats.

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.

That’s it. No fancy talk. No mumbo jumbo. It’s that simple. 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. (An analysis by my colleague Jim Lowell, editor of Fidelity Investor, finds the same pattern among that fund family’s offerings.)

I did not say that this strategy beats the market every time year in and year out. I didn’t tell you it was a lock on doubling or tripling your money every year. And I’ve never advocated that you sink your entire stash into this year’s “hot hands”fund. That would fly in the face of the diversified investment approach that I preach to all Vanguard investors.

I have looked at the best and worst Vanguard equity funds for each year between 1981 and 2007. 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.

The methodology isn’t complicated. And it works. Following a “hot hands”investment strategy at Vanguard from the end of 1981 through the end of 2007 would have netted you a total return of 10,647%, compared to a return of 2,064% for Vanguard Total Stock Market index fund. Playing the contrarian and buying the previous year’s worst fund, however, has proven to be an awful idea. (It has for Fidelity’s funds as well—Editor.)

In 2008, the question of mechani­cally following Vanguard Growth Equity (VGEQX) as the “hot hands”fund is not an easy one. I find it hard to reconcile Growth Equity’s claim to being “sector neutral” with the details of its portfolio, which is extremely heavy in technology stocks. Plus, Growth Equity is one of the riskiest of Vanguard’s funds, and can eat up your portfolio with losses faster than Jack Bogle can say “stay the course.” Despite last year’s 22.5% gain, shareholders are still trying to climb back from the devastating 68.7% loss suffered during the last bear market.

For those who do want to follow the strategy but are wary, as I am, of Growth Equity manager Turner Investments, an easy alternative is the Fidelity NASDAQ Composite Index Tracking fund (NASDAQGM: ONEQ). ONEQ and Growth Equity have about matched one another on the risk and return scales. If you really want high technology, go for the PowerShares QQQ (NASDAQGM: QQQQ), which has outperformed Growth Equity by a lot. Either way, 2008’s “hot hands”fund, and its alternatives, are bound to give investors a run for their money.

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