Mutual Funds
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2 'hot hands' for 2003
Buying funds that just had a good year -- and holding them for a year -- is paying off again. Two 'persistence of performance' strategists make their picks.
By Timothy Middleton
An investment strategy that fell to pieces during the Internet bubble has gotten itself put back together again. Hot hands are hot again.
Investing in proven winners is the backbone of many investment approaches, including the so-called hot hands strategy. The idea is to buy last years best-performing mutual fund and hold it one year, on the theory that whatever made it successful is still happening.
Finance professors call it persistence of performance and have demonstrated that it works in foreign as well as American equity markets.
Persistency of performance picks have gained 19.1% per year, compared to a 13.1% gain for the average diversified fund since 1975, says Sheldon Jacobs, the editor of the No-Load Fund Investor newsletter who has been recommending the strategy since 1991.
Dan Wiener, editor of the Independent Adviser for Vanguard Investors, adds: Not only do hot hands stay hot, cold hands really stay cold. You just get hammered buying the worst fund, and you do quite nicely, thank you, buying the best. Wiener began picking hot-hands funds in 1995.
The picks of both newsletters, each rated highly by Hulbert Financial Digest, beat the market last year. This year, Jacobs is recommending Royce Special Equity (RYSEX), a small-capitalization value fund that advanced 15.3% last year. Wiener is backing Vanguard Global Equity (VHGEX), a world-stock fund that held losses last year to 5.6%.
Widespread use
Finance journals of the 1980s were full of learned articles on persistence of performance. It has been documented both for individual stocks and for mutual funds. The Value Line Investment Survey, one of the most successful stock-selection systems, employs it, and so does the NoLoad FundX newsletter, which uses it to build fast-changing model portfolios.
Jacobs and Wiener tailor their strategies to less-aggressive investors who want to play only a single fund and want to swap funds only once a year.
The market moves in cycles, many of which last three to five years, says Jacobs. His strategy leads you into such funds in their second year. In the 27 years he studied, through 2002, the strategy of buying last years top fund beat the average fund 18 times and tied once.
Four of the eight years the strategy didnt work, however, were bunched between 1996 and 2000. Jacobs blames that failure on the technology boom, which rained outsize blessings on sector funds at the expense of diversified portfolios. Jacobs rules out sector funds, because hes convinced they dont persist as reliably as diversified funds.
In general, however, his picks have done splendidly. PBHG Clipper Focus (PBFOX), the pick for 2001, managed to gain 11.8% that year, when the average stock fund in Jacobs database declined 8.1%. The pick for 1999, Transamerica Premier Aggressive Growth (TPAGX), shot up 54.3%, beating the average by more than 20 percentage points.
This years pick, Royce Special Equity, ranks among the top 2% of small-cap value funds in the Morningstar database. But Jacobs didnt pick it for fundamental reasons -- its performance last year simply put it the top of his database.
Too much too soon
In the real world, the fund faces an obstacle that has shattered others of its kind in the past -- a flood of assets that overwhelms the tiny market for the small-cap companies the fund pursues.
At the end of December, the funds assets had ballooned to $394 million from $219 million three months earlier. Such a sudden influx of cash has swamped small-cap managers in the past, including one of Jacobs' picks.
His recommendation for 1998, Safeco Growth Opportunity (SAFGX), which had surged 50% the prior year, performed miserably, eking out a 4.4% gain in a year the average fund spurted 14.6%. Meanwhile its assets had mushroomed to $1.6 billion from $196 million. As Jacobs ruefully admitted at the time, manager Tom Maguire just couldnt handle that.
Wiener limits himself to picking Vanguard funds, so his universe of potential picks is scores of funds, rather than hundreds. Like Jacobs, he eschews sector funds, but unlike him, he doesn't ignore foreign-stock funds. Vanguard Global Equity has about a third of its assets invested in the United States and the rest overseas.
Wiener has been publishing hot-hands picks since 1995, when he recommended Vanguard Primecap (VPMCX). In the intervening years, his picks have beaten his benchmark, Vanguard Total Stock Market Index (VTSMX), six times, tied once and lost once.
The loss was 1997, when Vanguard Windsor (VWNDX) advanced 22%, about 30% less than Vanguard Total Stock Market.
Setting a record
Wieners pick last year set a record, although not one he relishes. Vanguard Selected Value (VASVX) fell 9.8%. Thats the first time ever the best fund was in the negative column, he says. This years selection also finished in the red, and that is the first fund that lost money and still got itself named the hot-hands funds, he admits. But this is also the worst bear market in at least a generation, he adds.
And although Wieners picks are also quantitatively driven, he likes Global Equity for fundamental reasons, as well. Manager Jeremy Hosking has a mid-cap orientation and a value orientation, and he keeps between 35% and 45% of assets in the United States. So its not an aggressive call only on foreign stocks, the editor says. This is not a fund I have to think twice about.
There are other ways to play hot hands, especially if you enjoy exploiting the MSN Money screening tools.
Superior performance dies out quickly, says Jeffrey Busse, an assistant finance professor at Emory University in Atlanta. What we find out in our work is that its more important to focus on the last quarter, instead of the last year. Fund performance also tends to degrade after only a few months, he adds.
Quarterly lists of top-performing funds are published widely, but they tend to be dominated by only one or two sectors. Using MSN Money's Deluxe Screener to eliminate sector funds, I turned up Fidelity Advisor Leveraged-Company Stock (FLSCX), which shot up 27.6% in the fourth quarter.
It has advanced about 11% so far this year. The fund invests in the most economically vulnerable companies, which are hurt the most in recessions but benefit most when recovery begins.
At the top of the list
As of Dec. 31, the funds top positions included EchoStar Communications (DISH, news, msgs), AES Corp. (AES, news, msgs), AmeriCredit (ACF, news, msgs), American Financial Group (AFG, news, msgs) and Level 3 Communications (LVLT, news, msgs).
(Actually, the screener turned up Fidelity Advisor Leveraged-Company Stock (FLVIX), the no-load version of this fund, but it has limited availability. The least-expensive version for retail investors who intend to own it for only a few months is the funds' class C shares, FLSCX, which have a 1% redemption fee.)
If you decide to adopt a hot-hands strategy, you have to accept the discipline it requires -- buying funds on the faith of the system, then selling them a year (or a quarter) later, whether you want to or not.
If you dont follow this drill, youre doing nothing more than chasing performance, which at some point almost invariably turns from hot to cold. Selling is just as important as buying in this system.
Personally, I dont invest the hot-hands way. But I do enjoy studying the funds the system turns up. Sometimes they're mediocre portfolios enjoying brief good fortune, like Safeco Growth. But sometimes they're gems, like Clipper. Good ideas are good ideas, wherever they come from.
At the time of publication, Timothy Middleton owned or controlled shares of the following securities mentioned in this article: Vanguard Total Stock Market Index Fund and PBHG Clipper Focus.
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