Swedroe: Turns Out The ‘Smart Money’ Isn’t

February 10, 2017

Institutional investors are generally considered “smart money” that exploits the behavioral biases of “dumb” retail money. However, there have been some holes poked in that idea recently.

For instance, Roger Edelen, Ozgur Ince and Gregory Kadlec, authors of the study “Institutional Investors and Stock Return Anomalies,” which was published in the March 2016 issue of the Journal of Financial Economics, write that while prior research had found a positive relationship between smart money and return anomalies at shorter time horizons (three to 12 months), it turns negative for longer horizons.

Study Findings

They found: “Not only do institutional investors fail to tilt their portfolios to take advantage of anomalies, they trade contrary to anomaly prescriptions. Most notably, they have a strong propensity to buy stocks classified as ‘overvalued’ (i.e., the short leg of anomaly portfolios). For example, during the anomaly portfolio formation window (prior to anomaly returns) there is a net increase in both the number of institutional investors and fraction of shares held by institutional investors in short-leg stocks for all seven of the anomalies we consider. In four of the seven anomalies there is significantly greater institutional buying in short-leg stocks than in long-leg stocks. There is significantly greater buying in long-leg stocks in only one case.”

This surprising finding was in sharp contrast to prior research on performance, with the difference being the horizon period studied. They confirmed this horizon effect, finding a significant positive relation between quarterly changes in institutional holdings and next-quarter returns that turns significantly negative as the time horizon extends to a year or longer. Thus, the authors concluded that “while institutional trades seem to be informed when evaluated over short horizons, that assessment seems premature when evaluated over a longer horizon.”

These findings suggest that institutional investors actually fail to exploit well-known anomalies. Instead, they contribute to their persistence. Thus, the short-term outperformance may not be the result of a “smart money” effect, but instead a result of the price pressure associated with persistent institutional trading, as opposed to informed trading.

This hypothesis is consistent with the findings of George Jiang and H. Zafer Yuksel, authors of the study “What Drives the ‘Smart-Money’ Effect? Evidence from Investors’ Money Flow to Mutual Fund Classes,” which was published in the January 2017 issue of the Journal of Empirical Finance.

By studying mutual fund flows for retail (unsophisticated) and institutional (sophisticated) investors, they found that short-term persistence in performance is not due to the so-called smart money effect, but was instead caused by persistent flow. And the persistence of short-term performance then experiences a long-term reversal. In other words, institutional investors (at least institutional mutual funds) are also noise traders who can contribute to mispricings.


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