Why Following the Winners Is for Losers; Last year’s top performers will likely lag behind the market in 2014.

Why Following the Winners Is for Losers

Last year’s top performers will likely lag behind the market in 2014.

MARK HULBERT

Updated Jan. 3, 2014 4:26 p.m. ET

“Past performance is no guarantee of future results.”

This phrase, ubiquitous in the small print of financial products, often falls on deaf ears, according to Adam Reed, a finance professor at the University of North Carolina at Chapel Hill. “Investors have a tendency to rush into those funds that are at the top of the previous year’s performance rankings,” he says, citing numerous studies.They shouldn’t. The evidence is that last year’s top performers will lag behind the market in 2014—if not lose a lot of money.

You should instead be focusing on strategies with superior track records over far longer than just the last 12 months. More like 15 years, in fact.

Consider a hypothetical portfolio that, each Jan. 1, began following the strategy espoused by the investment newsletter that—among the more than 500 tracked by the Hulbert Financial Digest—had the best record over the previous year. Over the past two decades, this portfolio would have been a disaster, losing an average 17% a year.

Such a “follow the winners” strategy didn’t trail the S&P 500 every year. But in the majority of years it did, and in a handful of cases it suffered huge losses. That is because one-year performance rankings will almost always be dominated by high-risk strategies that hit it big. When they don’t pan out, those same strategies also can lose big.

Take the portfolio with the best 2013 return, according to the Hulbert Financial Digest: the “Traders Portfolio” of the Medical Technology Stock Letter, edited by John McCamant. It gained 216% in 2013 by investing in emerging biotechnology companies. The S&P 500, by contrast, returned 32%, including dividends.

When judged by the volatility of its returns, a common measure of risk, the portfolio has been more than three times riskier than the market as a whole. Its worst single calendar-year performance, in 2008, was a loss of 68%, versus a loss of 37% for the S&P 500 index, assuming dividends were reinvested.

Mr. McCamant, in a telephone interview, acknowledged the volatility inherent in the biotech sector, though he added that, in the future, he will be “doing his best to manage that volatility.” He says that “biotech stocks are one of the premier growth sectors going forward,” and that even though another 216% gain in 2014 is unrealistic to expect, “a triple-digit gain is still achievable.”

So does the “first shall be last” pattern mean you should instead follow the lead of the worst performer of the previous year? Absolutely not. A portfolio that did that over the past 20 years would have lost even more than the follow-the-winners strategy.

That shouldn’t be particularly surprising, since the bottom of the one-year performance rankings also will be dominated by risky strategies whose bets didn’t work out.

The need to avoid huge amounts of risk has suggested to some an amendment to the follow-the-winners strategy: Focus only on lower-risk approaches, avoiding those that concentrate on a single industry sector or which borrow heavily to increase the size of their bets. This amended approach performs better than the plain-vanilla follow-the-winners strategy—but it, too, has ultimately proved disappointing.

Consider a strategy introduced at the beginning of 1992 by Sheldon Jacobs, then the editor of an investment newsletter called the No-Load Fund Investor. Each year it followed the previous year’s best-performing diversified U.S. stock mutual fund that could be purchased without a sales commission.

That strategy didn’t perform appreciably better than the S&P 500 over the next 19 years, however, and in 2010—after three years in a row of underperforming the average diversified U.S. stock fund—the newsletter stopped recommending it.

Mark Salzinger, who in 2003 succeeded Mr. Jacobs as editor of the No-Load Fund Investor, said that disappointing performance was the reason he decided to stop featuring this follow-the-winners strategy in his newsletter.

You would do much better to focus on performance over far longer periods than the past 12 months. That is because, when picking an adviser based on his track record, you implicitly are betting that the future will be just like the period over which that record was produced.

Picking an adviser on the basis of 2013’s returns, for example, is tantamount to betting that 2014 will be just as good a year for the stock market as last year. But if you were confident that the market this coming year would be up more than 30%, you wouldn’t need an adviser in the first place.

While there is no magical track-record length on which you should always focus, 15 years is a good rule of thumb. The past 15 years—from the beginning of 1999 through the end of last year—encompass two powerful bull markets as well as two punishing bear markets.

The investment newsletter with the best 15-year returns, among those monitored by the Hulbert Financial Digest, is a service titled the Turnaround Letter, edited by George Putnam. It focuses on out-of-favor stocks that Mr. Putnam judges to have attractive long-term potential. Its model portfolios have produced an average annualized return of 14.2% over the past 15 years, versus 4.7% annualized for the S&P 500 index, assuming dividends were reinvested.

Recent additions to Mr. Putnam’s buy list include EMC, EMC 0.00% the data-storage company; PennyMac Mortgage Investment Trust, PMT +0.04% a financial-services firm; and Layne Christensen, LAYN +0.60% a water-management company.

The U.S. diversified equity mutual fund with the best 15-year return, according to Lipper, is the Turner Emerging Growth Fund, with a 1.4% annual expense ratio, or $140 per $10,000 invested. It has produced a 17.6% annualized return over the last 15 years by investing in small-cap stocks.

Its largest current holdings are Huron Consulting Group, HURN +0.77% which provides consulting services for organizations in financial distress; Middleby, MIDD +0.82% which manufactures food-service equipment; and Cracker Barrel Old Country Store,CBRL +1.12% the restaurant chain.

One word of caution: Even though you can increase your chances of success by picking your adviser based on long-term performance, beating the market is by no means guaranteed. For those of you who don’t want to even bother analyzing the year-end performance rankings, a broad-based index fund remains the obvious choice.