Fund industry dogma dictates that past performance is not a guarantee, nor a predictor of future results. On the face of it, this sounds reasonable. But in 1995, I discovered that one momentum strategy, applied correctly, CAN predict future results. I call it "Hot Hands."

My Hot Hands thesis is 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. It’s that simple.

But how does this work, and why?

One of the reasons that Hot Hands works at Vanguard and not within the greater universe of funds is that Vanguard’s fund objectives and investment policies are very well-defined (see also, "How to Increase Profits with Vanguard Mutual Funds"). 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. If they don’t, then generally Vanguard fires them. One thing Vanguard wants is managers who strictly follow their investment styles and objectives. So using the prior year’s performance as a guide for selecting Vanguard equity funds is not only useful, but very profitable (see also, "Vanguard Funds: Fear, Fodder, Facts and Financials").

That’s good, because in most markets once an investment trend takes hold, it tends to keep going for a while before another trend takes its place. So, if a fund manager’s strategy is “hot,” then it tends to stay “hot” for a while. In my research I have looked at the best and worst diversified equity funds at Vanguard for each year between 1981 and 2007. I also exclude any funds that don't meet my diversification criteria.

Vanguard's Hot Hand Fund

From this universe of funds, I can then determine which is the “hot” fund each year, follow it in the next year and compare its return with the market benchmark. When I make those comparisons, I measure rolling three-year, five-year and 10-year returns for the Hot Hands fund against Total Stock Market Index (VTSMX) a proxy for the entire stock market.

Here’s the bottom line: