How to Beat the Market with Mutual Funds

Cam Hui seems to have found a simple and low-risk way of outperforming the S&P 500 by 6% a year. If you want to try this at home - and I wouldn't recommend it - here's what you do:

1. At the beginning of the year, go to morningstar.com and look at the "growth" funds. Pick the best-performing no-load fund with assets of over $1 billion and an expense ratio of less than 1%. Do the same for "value" funds. Put half of your money into each fund.
2. Every month, check to see how your funds are doing. When you write your monthly savings check each month, divvy it up with most of the money going to the underperformer of the two funds, so that the amount of money in each fund is evened out. Alternatively, move money from the outperformer to the underperformer, so that they remain 50-50 in terms of dollars invested.
3. At the end of the year, rinse and repeat: get rid of the old two funds, and pick the latest top fund in each category instead.

Hui reports that this strategy does very well indeed - so well, in fact, that he's comfortable going one step further and actually shorting the S&P 500 at the same time. Do that, he says, and you're golden:

For the period from December 1998 to Janaury 2008 the synthetic equity market neutral portfolio showed a very respectable annualized return of 6.4% (after fees) and a Sharpe ratio of 0.9.

I'd love to know what Blaine Lourd thinks of that. Hui seems to be saying that if you pick the hottest mutual-fund managers of the moment, they have enough momentum behind them to continue to outperform the market for at least a year.

Now this strategy isn't easy even when it is working. You have to be reasonably active, moving your money around on a monthly basis. You have to take money out of an outperforming fund, and put money into an underperforming fund, every month - which can't be easy. And if you short the S&P 500 at the same time, you're also constantly running the risk that your funds will go down while the stock market goes up, leaving you with a magnified loss.

What's more, Hui has backtested this strategy only to 1998: it's managed to withstand a sudden stock-market crash when the dot-com bubble burst, but it's never been tested over a longer and slower bear market. Even so, I'm very impressed at how well this strategy has worked over the past decade. I would never have predicted such consistent performance. And somehow I doubt that the outperformance is going to continue for the next 10 years.

(Via Abnormal Returns)