(01/09/12) The Hot ETF for 2012

Here's a look at the method behind the picking my annual Hot Hand, so even if the pick misfires, at least you can buy into the reasoning as well as the ETF, writes Jim Lowell of Forbes ETF Advisor.

My Hot Handpick for 2011, Rydex S&P Midcap 400 Pure Growth (RFG), gained just 0.2% vs. the S&P 500’s gain of 2.1%.

Last year’s loss reminds us in a gentle way that not every year is a winner for our Hot Handsmethodology. And before I get to 2012’s Hot Handpick, I want to review that methodology and its history of success.

It's a simple strategy: buy whichever fund has performed best in the previous year and hold onto it throughout the upcoming one. The rewards, as demonstrated by 11 years of data, are stunning to say the least.

A Hot Caveat
Let me remind you, again, that this strategy has not beaten the market every year. As I say every year, that’s worth repeating—this strategy has not beaten the market every year.

2008 proved to be a case in point. Our Hot HandETFfor 2008 was Guggenheim BRIC (EEB), which lost 54.7% vs. the 37% loss for the S&P 500. But in 2007, our Hot Hand pick was iShares S&P Latin America 40 (ILF), which delivered 48.5% vs. 5.5% for the S&P 500.

Another caveat: I never advocate investing your entire savings in the latest Hot HandETF. That would foolishly fly against the diversified investment approach that I practice and preach. That said, I believe that many growth-oriented investors could improve their performance by putting a reasonable (5% to 10%) portion of their money to work following my Hot Handstrategy.

The Rules
Here are the ground rules for the strategy. First, I looked at all of the diversified equity ETF’s we track for each year between 2000 and 2011. I excluded single-sector (Select, Real Estate, Utilities) funds and balanced funds (those with significant bond positions).

On the international side, I did include the diversified internationals, but (analogous with excluding sector funds) I excluded the geographically non-diversified (regional and single-country) international funds. Where ETF’s didn’t exist, I included indexes that predated the current ETF’s that are based on them.

It is interesting to see how a simple system—and you can’t get much simpler than “buy last year’s ETF winner”—can be made that can beat the market and most professional managers. Using the prior year’s performance as a guide for selecting ETFs is highly profitable. And ignoring it, or going with the “dogs,” as some investment advisors who use a “contrarian” approach like to suggest, can lead to market-lagging results.

The methodology isn’t complicated. There’s no magic black box. But does it work?

From the end of 2000, when you would have put your money into iShares S&P Mid Cap 400 Value (IJJ), through the end of this year when you would have had your money in Rydex S&P Midcap 400 Pure Growth (RFG), you would have netted a total return of 238.5%, while the return for S&P 500 would have been 17%.

Enter the Hot Handtrack record: On an annualized basis, that’s 11.7% for Hot Handsversus 1.4% for the market and just 1.4% for the “worst” fund, contrarian strategy.

Buying the Hot HandETF doesn’t guarantee you are going to beat the index every year. In fact, the Hotfund only beat the index in just eight out of 11 years.

But that’s not the point. It’s the accumulation of market-beating returns that really makes the difference. (To put it another way, the good years were better than the bad years were bad.) And over the long haul, this strategy has delivered hedge fund-like gains without any of the hedge-fund snafus.

My 2012 Hot Hand ETF
It’s WisdomTree Equity Income (DHS)! DHS invests in companies with high dividend yields.

The top three sectors are health care (19%), consumer staples (16.2%), and utilities (14.6%). The top ten holdings are AT&T (T), GE (GE), Johnson & Johnson (JNJ), Pfizer (PFE), Procter & Gamble (PG), Verizon (VZ), Philip Morris Int’l (PM), Merck (MRK), Intel (INTC), and ConocoPhillips (COP).