I Read Academic Research So You Don’t Have To: Which Money is Smart?

By Ann C. Logue, MutualsAdvisor.com | Oct 06, 2008 | comment

Is any money smart these days? I’m sure someone has made a heck of a profit off of the recent market decline, but who? Who are these smart - or lucky - investors? Is there any way to profit from their choices?  

In February of this year, the Journal of Finance published an article by Aneel Keswani of the Cass Business School in London and David Stolin of the Toulouse Business School in France that may offer a few clues. Entitled "Which Money is Smart? Mutual Fund Buys and Sells of Individual and Institutional Investors," the authors looked at whether investors are able to find funds that are likely to do well in the future. If they put more money into funds that then do well, then they are smart enough to figure out where the market is going and which portfolio managers are going to do well.

Working with nine years of data from the United States and the United Kingdom, the authors looked at how much of a fund’s increase in asset size came from performance and how much from new money. In many cases, they had data on new investments. Then they looked at funds that had big increases from cash inflows to see how they performed in later periods. Were investors making good choices, or were they following herds or investing in funds past their performance peak?

The news is good! Keswani and Stolin found that mutual funds that had new money inflows outperformed those that did not, which would mean that new money beats old money. The relationship was not limited to small funds or large funds, and it seems to last for about four months.  

More to the point, it shows that mutual fund investors are savvy about finding funds that meet their needs and switching between funds as necessary. In high-finance circles, there’s often an impression that mutual fund investors represent dumb money: they place their bets on the wrong funds, in part because they are swayed by flashy advertising or mentions on investment television shows. Some market analysts look at mutual fund flows as a contrary indicator: if mutual fund investors are excited about stocks, for example, they view that as a sign of future stock market weakness.  

This research can do more than just give investors confidence in their ability to make decisions. It also can be used to help predict future performance; if a fund is attracting new money, then it might be a good one to invest in. The effect is very short, though - four months - which means that investors hoping to use this as a signal have to act fast. Wait too long, and it will be gone.

The researchers have less evidence of the opposite effect: funds that have the largest net outflows show underperformance later on, but with lesser correlation. That’s too bad, because in this market, outflows are a lot more common than inflows.

Comments on this article

There are no comments for this entry yet.

Add your comments