(01/18/12) Play the Fidelity Hot Hand for 2012

Every year I pick one fund that looks like it’s set up for a big year, says Jim Lowell of Fidelity Investor.

My Hot Hand fundpick for 2011, Stock Selector Small Cap (FDSCX), lost -2.6% 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 Hand’s methodology. And before I get to 2012’s Hot Hand pick, I want to review that methodology and its history of success.

The Rules
Here are the ground rules for the strategy. First, I looked at all of Fidelity’s retail diversified stock funds for each year between 1983 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 broad international funds, but (analogous with excluding sector funds) I excluded the geographically non-diversified (aka single-country) international funds.

It is interesting to see how a simple system—and you can’t get much simpler than “buy last year’s winner”—can beat the market and most professional managers.

Using the prior year’s performance as a guide for selecting Fidelity funds 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.

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

From the end of 1983, when you would have put your money into Magellan (FMAGX), through the end of this year, when you would have had your money in FDSCX, you would have netted a total return of 6,774%, while the return for S&P 500 would have been 1,423%.

Enter Fidelity Investor’s Hot Hand’s track record: On an annualized basis, that’s 16.3% for the Hot Hand versus 10.2% for the market—and just 8.1% for the “worst fund" contrarian strategy.

Buying the Hot Hand fund doesn’t guarantee you are going to beat the index every year. In fact, the Hot fund only beat the index in 16 out of 28 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 Fund
It’s Large Cap Core Enhanced (FLCEX). FLCEX is a large blend fund that invests in companies found in the S&P 500 Index.

The top three sectors are information technology (20.1%), financials (12.7%), and health care (12.2%). The top ten holdings are Exxon Mobil (XOM), Apple (AAP), Chevron (CVX), IBM (IBM), Microsoft (MSFT), GE (GE), AT&T (T), Johnson & Johnson (JNJ), Pfizer (PFE), and Wells Fargo (WFC).