Smart Money and Mutual Fund Family
Abstract: This paper studies the smart money effect within mutual fund families by looking at monthly US equity open-ended mutual fund data between 2011 and 2019. Investors' money is said to be smart when it is able to predict future performance. By contrast, money is said to be dumb when it follows a strategy that reduces the wealth of investors (when investors buy funds that perform badly and sell funds that perform well in the future). This research investigates whether mutual fund investors are smart and able to identify positive and negative future performance among all funds on the market and within fund families. Previous studies show that fund families matter for investors, who are better at picking funds within families with which they have experience. To measure the potential smart money effect, this paper first distinguishes money that chases past returns (expected to be dumb) from the money not correlated with past returns and flows (expected to be potentially smart). To do so, the fund flow is regressed on its lagged performance and flows. The fitted values of the regression are the part of the flow correlated with the fund's past performance and flows, the so-called expected flow, and the residuals of the regression (uncorrelated part) are the so-called unexpected flow. This paper finds that the unexpected flow is smart when it comes to all funds within the market. The unexpected flow is able to predict the market rank of a fund and whether the fund will be a star (best 5% performing fund) or a dog (worst 5%) in the following month. However, no smart money could be observed within families. Investors do not seem to be able to identify a fund's future performance relative to the other funds within the same fund family. This study also documents the dumb money effect of the expected (i.e. return-chasing) flow. Both on the market and within fund families, an increase in the expected flow decreases, on average, a fund's rank as well as its probability to be a star, and increases the probability of the fund to be a dog in the next period. Overall, this paper finds weak evidence of smart money within the mutual fund market, which is restricted to only the best and worst performers. However, while the results are statistically significant, the economic significance and the magnitude of the effect remain low.
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