The academic literature documents a significantly positive relationship between mutual fund flows and short-term future fund performance. Specifically, mutual fund flows positively predict subsequent fund performance. There are competing theories to explain this relationship.
The first is the existence of a “smart-money” effect; namely, the ability of mutual fund investors to predict short-term fund performance and invest accordingly by moving money from poor performers to good ones. The second theory is that funds’ short-term predictability is driven by stock return momentum.
A third explanation for the positive flow-performance relation is what’s called the “persistent flow” hypothesis. Research has found that investor flow-related buying pushes up stock prices beyond the effect of stock return momentum and that fund performance owes more to flow-related trades than to managers’ skill.
Because fund flows have been shown to be highly persistent, mutual funds with past inflows (outflows) are expected to receive additional capital (redemptions), expand (liquidate) their existing holdings as well as drive up (down) their own performance in subsequent periods. This is a very different explanation than the smart-money hypothesis.
Retail Vs. Institutional
George Jiang and H. Zafer Yuksel contribute to the literature on this subject with their new study “What Drives the “Smart-Money” Effect? Evidence from Investors’ Money Flow to Mutual Fund Classes,” published in the January 2017 issue of the Journal of Empirical Finance. They shed new light by examining the flow-performance relation for retail as well as institutional investors (institutional investors have access to different share classes).
Research has shown that institutional investors tend to be more sophisticated, while retail investors are known to exhibit a number of behavioral biases. Thus, if the positive flow-performance relation is driven by smart money, we should expect it to be more pronounced among institutional funds.
Jiang and Yuksel also note that “investors of front-end load and back-end load classes tend to be those who value professional financial advice and pay brokers and advisors to select funds on their behalf. On the other hand, investors of no-load classes are likely those who self-manage their portfolios and engage in active investment strategies. Thus, investors of no-load fund classes may exhibit stronger behavioral biases. Again, if the positive flow-performance relation is driven by smart money, we expect it to be more pronounced among load classes.”
The authors’ study covered all actively managed domestic equity mutual funds in the Center for Research in Security Prices Survivor-Bias-Free U.S. Mutual Fund Database for the period 1993 to 2014. Jiang and Yuksel found there is a significantly positive relation between fund flow and subsequent fund performance—funds with net inflow outperform those with net outflow over the following month. In addition, they found that even though fund flow predicts subsequent fund performance for institutional and retail funds, the relation is stronger for retail funds, particularly the no-load retail class.
These findings provide support to the persistent-flow hypothesis, because if the positive flow-performance relation were driven by the “smart money” of mutual fund investors, we would expect the relation to be stronger among the funds with more sophisticated institutional investors.
Taking Outflows Into Account
Another finding from the study was that the significantly positive flow-performance relation is driven mostly by funds with net outflows, with the abnormal returns of funds having negative flows being of large magnitude and significant at the 5% level. Jiang and Yuksel also found that abnormal returns to funds with negative flows are of smaller magnitude relative to retail funds.
Finally, they found that the differences in performance are insignificant between funds with positive and negative flows. All this evidence casts further doubt on the veracity of the smart-money hypothesis. According to the smart-money hypothesis, investors should have the ability to identify not only the poor performers but also the good performers.
Jiang and Yuksel’s findings were confirmed in robustness tests using international funds and bond funds. Their findings seem to lead to one of two conclusions. The first is that the smart-money effect is not correct, and funds’ persistence in performance is due to persistent flow. The alternative is to believe that the smart-money effect is right, but it’s the retail money that is smart.
Unfortunately, there’s a large body of evidence to the contrary. Thus, we can conclude that once the momentum effect is accounted for, the persistent-flow effect drives any short-term persistence in performance.
Cash outflows lead to forced redemptions, which then lead to higher trading costs (not just in bid/offer spreads, but with market impact costs as well), driving prices lower. Cash inflows lead managers to add to existing positions, driving prices higher, at least in the short term.
In other words, pricing pressure, not manager skill, drives differences in returns, which conflicts with the smart-money hypothesis.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.