The Hottest Fund Around

12/09/2010 12:50 pm EST

Focus: FUNDS

Daniel Wiener

Editor, The Independent Adviser for Vanguard Investors

Daniel Wiener, editor of the Independent Adviser for Vanguard Investors, explains how going with the hot hand can pay big dividends.  

The October Hot Hands strategy is a momentum-based concept rooted in research I’ve conducted over the years and put into practice in a variety of forms for private asset-management clients.

As with any investment strategy based on price and performance momentum, it can have good periods and bad periods. If you’ve been following the travails of many in the hedge fund industry, you know that momentum-based investment strategies have had a tough time over the past couple of years as markets have swung from optimism to pessimism and back, favoring bonds, then small stocks, then foreign stocks and then back to domestics in a whipsaw. Until very recently, the markets have been unable to settle into a strong enough pattern to reap the kinds of rewards many momentum seekers are aiming for.

While the 12-month period ending in December remains my choice for my annual Hot Hands portfolio update for reasons of simplicity and taxes, October is a pretty strong candidate for “best overall.” Back-testing shows that using the Hot Hands methodology in any month can give you a long-term winner over the market. The differences: How often the strategy fails to beat the market, as well as the average level of outperformance over my testing period.

How to Discover Stars
Here’s some of the analysis that I used to come up with the focus on October over other months. The first step was to look at the performance of top-performing funds (ignoring the sector funds and international region-specific index funds) over the 12-month periods ending in every month of the year. Next, I calculated the return for each of these top funds over the ensuing 12 months.

The table above shows the average annualized market outperformance of a Hot Hands strategy that keys off of 12-month returns ending in each of the 12 months of the year, as well as the average level of market outperformance and worst year’s performance. The data is based on running the simulation over the past 18 years.

October looks very strong on all measures, with a good long-term average outperformance of 8.4% over the Standard & Poor’s 500 Index, good consistency with a small number of years in which the strategy fails (just four), and at its worst, a 13.9% gap when it failed to best the market.

SmallCap Growth Is on Fire
This year’s October Hot Hands fund is Vanguard SmallCap Growth Index Fund (VISGX), which returned 30.7% over the 12 months ending in October, a stellar performance given the market’s return. Please remember that a fund that qualifies for the Hot Hands strategy, or the October Hot Hands, may not be “rated” a Buy if I feel there are other funds with similar objectives that are better or I feel, on a qualitative basis, that there are better places to invest your money.

This momentum strategy is quantitative, not qualitative, in nature. So, while I currently have a Hold on SmallCap Growth Index, I have a Buy on the Vanguard S&P Small-Cap 600 Growth ETF (NYSEArca: VIOG). That doesn’t mean the former isn’t a Buy for those following the October Hot Hands strategy, though.

Over the 18 years for which I have data on this strategy, following the October Hot Hands would have yielded an annualized return of 14.9% versus 7.9% for the S&P 500 Index. Let’s see how this one pans out.

[James Oberweis recently picked seven small-cap growth stocks poised for big things next year—Editor.]

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