Money Is Smart: New Evidence From Investors’ Buys And Sells

Yeonjeong Ha
Pusan National University

Hyeongseok Kang
Korea Advanced Institute of Science and Technology (KAIST) – College of Business

Tong Suk Kim
Korea Advanced Institute of Science and Technology (KAIST) – College of Business

Heewoo Park
Korea Advanced Institute of Science and Technology (KAIST) – College of Business

March 31, 2016

KAIST College of Business Working Paper Series No. 2016-011


The existence of a “smart money” effect has been debated since Gruber (1996) and Zheng (1999) suggested investors select mutual funds that subsequently perform well. Using hand-collected data on monthly inflows and outflows, we examine the relation between fund flows and subsequent fund performance in the U.S. mutual fund market. Our results indicate that investors make smart choices when selecting mutual funds. In particular, their money flow into small funds and money flow out of large funds strongly predict future performance. The effects are robust after controlling for a momentum effect. We also show that investors’ fund selection ability exists even in top-performing funds, which means that the smart money effect is separate from investors’ return-chasing behavior.

Money Is Smart: New Evidence From Investors’ Buys And Sells – Introduction

Are investors skilled at selecting mutual funds? The performance predictability of mutual fund flows has gained academic interest since Gruber (1996) first addressed the issue. Gruber’s aim was to understand why the actively managed mutual funds sector dramatically expanded despite evidence that they underperform index funds on average. The author suggests that investors cleverly channel their money into funds that are more likely to subsequently outperform, a phenomenon called the smart money effect.

The smart money effect states that investors have fund selection ability. Specifically, mutual funds with greater cash flow exhibit better subsequent performance than those with less cash flow. Using a sample of U.S. equity funds during 1985–1994, Gruber (1996) finds evidence that the average performance of funds with net inflows is significantly positive, based on a riskadjusted performance measure.

Following Gruber (1996), a variety of studies have employed various methodologies and data sets to examine whether the smart money effect exists. Subsequent analysis by Zheng (1999), calculating quarterly implied flows, confirms that funds with positive net flow perform better than those with negative net flow over the short term. The author finds that this smart money effect is more noticeable for small funds. Sapp and Tiwari (2004), however, argue that the smart money effect is the result of prior studies overlooking the effect of momentum in stock returns. They claim that the smart money effect is fragile enough to be wholly explained by the momentum factor and the outperformance of funds with greater net flows is not due to the intelligence of investors. Keswani and Stolin (2008) investigate the existence of the smart money effect in the United Kingdom. They use monthly flows and exact net flows computed from the data, separating inflow and outflow. They document a robust smart money effect in the U.K. mutual industry due to the purchases of both individuals and institutions.

We reexamine whether investors have fund selection ability in choosing actively managed mutual funds that subsequently outperform. While prior studies of U.S. mutual funds approximate quarterly implied money flows using total net assets (TNA) and fund returns, we manually collect U.S. monthly mutual funds’ actual flow data separated into inflow and outflow. Using this hand-collected data, we empirically determine the presence of the smart money effect.

Smart Money, Fund Flows, Return-Chasing Behavior

Few studies use monthly U.S. mutual fund flow data. Whereas prior research on U.S. mutual funds uses quarterly fund flow and approximated net flow, ours employs monthly U.S. mutual fund flow data and actual net flow data considering inflow and outflow separately. Our data have several advantages. First, monthly fund flow data allow us to examine the short-term existence of a smart money effect more precisely than quarterly data do. If the smart money effect lasts only for the short term, for example, less than one quarter, quarterly fund flow data could misleadingly indicate the absence of any smart money effect. Using quarterly U.S. fund flow data, Sapp and Tiwari (2004) argue that the smart money effect disappears after controlling for a momentum factor. Our findings, however, suggest that the smart money effect still persists, despite controlling for a momentum effect.

Second, our data sample covers a recent period, 1994 to 2011, allowing us to explore the trading behavior of recent sophisticated investors. Ferreira, Keswani, Miguel, and Ramos (2012) find investors in advanced countries to be more sophisticated than in other countries. The more developed the fund industry, the more sophisticated the investors. Keswani and Stolin (2008) show that money is smart in the United States after 1990. The fact that the major portion of the sample period of Sapp and Tiwari (2004) is pre-1990 could be why they could not detect the smart money effect. In addition, since 1994, the SEC has required all mutual funds to disclose their investing activities. Investors can thus easily obtain fund data and construct more precise strategies.

Third, separating inflow and outflow allows us to accurately examine investors’ investment strategies. We investigate the effect of investors’ buy and sell decisions by distinguishing between inflow and outflow. The smartness of money inflow is highlighted in small funds while that of money outflow is remarkable in large funds. The smartness of investor behavior differs by fund size. The behavior of smart investors, who make investments in small funds and avoid investing in large funds, demonstrates that they are able to determine the optimal sizes of funds, as theoretically hypothesized by Berk and Green (2004). The results are somewhat consistent with their model. If an optimal fund size exists, investor money flow plays a role in finding it.

Along with evidence of the smart money effect, we find that investors are far more sophisticated than naive chasers of past fund performance. A number of earlier studies document that investors chase funds with past superior performance and that performance persists. Chevalier and Ellison (1997), Sirri and Tufano (1998), and Del Guercio and Tkac (2002) demonstrate that mutual fund investors chase high returns, cash flows into past good performers, and cash flows out of past poor performers. In addition, Hendricks, Patel, and Zeckhauser (1993), Goetzmann and Ibbotson (1994), Brown and Goetzmann (1995), and Elton, Gruber and Blake (2001) find that mutual fund performance persists. Hence, we consider the performance persistence of mutual funds to determine whether the smart money effect is only part of those phenomena. After we control for fund past performance, we still find that the smart money effect is separate from investors’ return-chasing behavior.

Smart Money, Fund Flows, Return-Chasing Behavior

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