Conventional wisdom says that’s dumb. Supposedly, a fund’s past performance doesn’t tell you how it’s likely to fare in the future. But surprise, surprise–maybe it does. Some recent studies suggest that a hot hand persists, at least for a short period of time. In theory, you can fatten your investment returns by switching your money, every year, into the diversified funds that have recently done the best.
Some caveats, before I tiptoe into this controversial thesis. What works on paper won’t necessarily make you rich. You need time, discipline and rigorous fund selection to pursue the hottest hands. Your reward may be marginal, after costs. Your quest will almost certainly fail if you pay sales charges when you buy and capital-gains taxes when you sell.
A hot-hands strategy works best- if it works at all- for investors who purchase no-load funds, in tax-deferred plans that offer a wide investment choice. Typically, that means an Individual Retirement Account or Keogh plan that you run yourself. In a 401(k) plan that offers only a handful of funds, your best choice is still a combination of stocks and bonds that you buy and hold.
Rising bets: But let’s say you’d rather bet some money on the funds that are rising fast. Odds are, that’s a gamble you won’t regret, says Martin Gruber, chairman of the finance department at New York University’s Stem School of Business.
Gruber believes that success breeds success, over short periods of time. That’s what he found in recent, risk-adjusted study of diversified U.S. stock funds during the decade ending in 1994. Gruber looked at the funds in each year’s top performance tier, and compared their gains with a comparable index fund (index funds rise and fall with the market as a whole). Those top funds outdid the index funds by almost one percentage point.
Investors, he found, directed their money into those better-performing funds and were rewarded for doing so. Overall, new investments in managed funds gained 0.4 percent more the first year than they would have in index funds.
After that first year, however, the picture begins to change. The gains on your investment slow. In the third year, you probably won’t be beating the market anymore. On average, says Gruber, old money that stayed in the funds he studied underperformed the index funds by 0.45 percent a year. But it’s one thing to know how to find a likely list of quick winners and another to put that strategy to work. You have to take pleasure in switching your money around a lot. You have to analyze all the funds in the highest tier. You have to make some choices among them. which increases your risk. Maybe the funds you picked will do better than average. On the other hand, maybe they’ll do worse.
A simpler version of Gruber’s approach comes from Sheldon Jacobs, editor of The No-Load Fund Investor in Irvington-on-Hudson, N.Y, At the start of each year, he invests in the highest-ranked U.S. diversified equity fund (ignoring the internationals and the funds devoted to a single industry). Twelve months later, he takes his profits and rolls them into the next year’s ranking fund. Had you followed this aggressive rule since 1975, a $1,000 investment would have grown to $78,108, he says, compared with only $15,5134 for investors in the average fund.
How’s he doing in 1996? So sorry you asked. Last year, Wasatch Mid-Cap led the pack, but this year it went nowhere. Hot hands do turn cold. If the stock market drops, as often happens after a presidential-election year, today’s top performers could look bad. But so what? Jacobs’s system guessed wrong in five years out of 22, and still produced super long-term gains.
The index option: But what if you’d rather buy stocks and hold them? For you, the funds run by money managers pose a risk, Gruber says. The longer you hold them, the greater the chance they’ll underperform an index fund.
Gruber thinks buy-and-holders should keep their core investments in index funds- specifically, those with annual expenses under 0.$ percent. For the largest low-cost selections– stock funds, bond funds and internationals-try the Vanguard Group in Valley Forge, Pa. (Disclosure: Vanguard rims NEWSWEEK’S 401(k).)
Index funds are boring, of course. That’s why millions of investors prefer the flashier funds that money managers run. If Gruber’s studies are right, however, most of those funds can make you happy only for a year or two. Then you’ll succumb to performance envy, as other funds climb and your own settles hack. You’ll find it tough to beat the index, over time.
A few funds have defied the odds and yielded superior results, says Kurt Brouwer of Brouwer & Janachowski in San Francisco, who invests clients’ money in mutual funds. His star list of stock funds currently includes Brandywine, Harbor Capital Appreciation, Oakmark, Selected American Shares (a no-load version of New York Venture) and Vanguard Wellington. Still, you can’t know if their long-term records will repeat.
Mark Carhart, finance professor in the School of Business Administration at the University of Southern California in Los Angeles, links top fund performance to two principal things: low expenses (with no sales loads) and owning the right stocks at just the right time. That’s not genius, he says, that’s luck. He sees only slight evidence of special investment skill, despite the awesome records of Windsor’s legendary John Neff or Magellan’s Peter Lynch. In most cases, high performance derives from the market’s invisible hot hand. It blesses first one fund and then another. The surest form of risk-taking lies in following that hand.
