Looking for a simple, straightforward way to beat the market? Try buying last year’s best-performing exchange-traded fund and holding it through the year, says Jim Lowell, editor of Fidelity Investor, an independent, Boston-based newsletter about investing in Fidelity Investments’ funds.

The logic behind this approach is simple, says Lowell, who is also president of the U.S. Fund Family Shareholder Association. Although market trends tend to last years rather than months, investors are better off with a one-year time frame in which the danger of buying too late in the cycle is greatly reduced. This strategy means you could at least ride the subsequent 12-month wave to stay ahead.

If you followed his “hot hands” strategy for 2005, it would have been a great choice: the previous year’s top ETF was the iShares S&P Latin American 40, which gained 54.5% in 2005 — in U.S. dollars, at least.

Although this strategy reveals a healthy trend, the data go back only five years — hardly long term, but prior to that there weren’t enough ETFs to work with, he says.

Buying the “hot hand” won’t guarantee you will beat the index every year. But that is not the point, he believes. It is the accumulation of market-beating returns that really makes the difference. So far, the good years have been better than the bad years were bad, so over the long haul this strategy should work, he maintains. To hedge their bets, however, growth-oriented investors should consider putting no more than 10% of their portfolios in the chosen ETF.

To prove his case, Lowell looked at the U.S. equity universe, excluding sector and balanced ETFs, for each year between 1999 and 2005. Bonds don’t figure into his calculations and, because the life cycle of sector rotation can be brutally short, working with funds that specialize in gold, real estate or technology means that you will probably need to buy and sell more than once a year. The more trading you do, the more you will increase your taxes, which, in turn, will reduce your gain.

Lowell believes that when you use more broadly diversified funds, you are riding broad market trends, not market sectors. That is why, on the international side, he included the diversified international and regional ETFs, but excluded any concentrated single-country offerings.

Following the strategy from the end of 2001 through to the end of 2005 would have netted a total cumulative return of 193.9%, while the Standard & Poor’s 500 composite index delivered a pitiful 2.7%.

So, how can you make the best use of Lowell’s findings? Let history repeat itself, he advises: buy last year’s top performer, iShares S&P Latin American 40, once again.

One of the reasons why the strategy works with ETFs but not necessarily with other fund families is that index managers do what they do, and keep doing it, no matter how the markets change around them, Lowell believes. But other observers think that actively managed funds can do the job just as well.

Don’t rely on one sector

Sheldon Jacobs, founder of U.S.-based The No-Load Mutual Fund Investor newsletter, put together a portfolio in 1975 based on the persistence of individual fund performance from one year to the next. He, too, selects only diversified funds because sector fund performance is much more erratic and even the best managers seldom overcome the drag of an out-of-favour sector.

Similarly, his strategy avoids funds that are largely short because he maintains that bear markets are less likely to persist than bull markets.

Over the past 30 years, Jacobs’ portfolio has outperformed the average no-load equity fund by roughly six percentage points annually, according to data from Hulbert Financial Digest. As well, using this methodology, Jacobs’ top pick for 2005, which had gained 42.5% in 2004, more than doubled the average fund.

But Costas Siriopoulos, a professor at Greece’s University of Macedonia, isn’t as sanguine about the concept of performance persistence. Studying U.S.-based equity funds that invest in European stocks and have kept the same management team in place for more than three years, he found that the “hot hands” phenomenon wasn’t particularly long-lasting.

Funds that performed well during the evaluation period continued to generate superior performance only over the next four months, not a full year. But he did concur that it was the well-diversified funds, not the heavily concentrated ones, that were most likely to deliver those returns. IE

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