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Where Are Smart Investors? New Evidence of the Smart Money Effect

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Prior research debates focus on whether investors are smart enough to invest funds that subsequently outperform. This paper documents a robust smart money effect among small fund investors who invest in the top performing funds, even after
  1 Where Are Smart Investors? New Evidence of the Smart Money Effect Hsin-Yi Yu *  Department of Finance, National University of Kaohsiung, Abstract Prior research debates focus on whether investors are smart enough to invest fundsthat subsequently outperform. This paper documents a robust smart money effectamong small fund investors who invest in the top performing funds, even after controlling for the momentum factor argued by Sapp and Tiwari (2004). I further explore the reason for the smart money effect and find that such outperformancecomes from market timing ability of smart investors. The market timing abilitydistinguishes smart investors from investors who naively chase the winners.JEL classification: G11; G20Keywords: Smart money effect; Fund cash flow; Fund performance; Timing ability _______________________  * Tel.: +886 7 5919709; fax: +886 7 5919329; E-mail addresses:  2 Introduction  If there are smart investors, would they put money in poorly performing funds?Recent studies debate whether investors are smart enough to invest funds that willoutperform in the future, so-called the ‘smart money effect’ (Gruber, 1996; Zheng,1999; Sapp and Tiwari, 2004; Keswani and Stolin, 2008).To provide evidence for thesmart money effect, most studies pay attention to fund flow of all equity fundinvestors in aggregate. However, if investors are really smart, i.e. they can learn from prior investments, they will pick top performing funds as their final destination andstay. That is, top performing fund group should be the most possible place to identifysmart investors. This paper provides evidence for the above argument. Furthermore, Ialso find that smart investors possess market timing ability to earn risk-adjustedreturns which cannot be explained by the momentum effect. In other words, thesmartest investors not only perceive which to invest but also detect when to invest.Research concerning the smart money effect in the mutual fund context was initiated by Gruber (1996), confirmed by Zheng (1999), challenged by Sapp and Tiwari (2004),and finally reexamined by Keswani and Stolin (2008). Gruber (1996) and Zheng(1999) name the ‘smart money effect’ and find evidence that a group of sophisticatedinvestors seem to identify the superior funds and invest accordingly to outperform themarket. However, after controlling for the momentum effect, Sapp and Tiwari (2004)demonstrate that the smart money effect is no longer significant. They conclude thatthe outperformance is due to the momentum effect rather than the intelligence of investors. Subsequently, Keswani and Stolin (2008) attribute the insignificant smartmoney effect exhibited by Sapp and Tiwari (2004) to the use of quarterly data and theweight they put on the pre-1991 period. Keswani and Stolin (2008) use monthly data  3 of U. K. funds and find a robust smart money effect in the U. K.It is interesting to notice that previous studies, no matter whether they support or reject the smart money effect, they focus on all fund investors in the market, of course,including naive investors who may invest in the worst performing funds, to investigatethe smart money effect. In other words, the smart money effect may be diluted byusing all fund investors in the market as observations. In addition, according to thesamples used in previous studies, prior researchers implicitly assume that smartinvestors can be found in poorly performing funds. However, if smart investors arereally “smart”, they should be able to avoid poorly performing funds and invest in top performing funds. Therefore, as opposed to pervious studies, I investigate the smartmoney effect by examining the risk-adjusted returns of investors in different fundgroups ranked by fund excess returns. If investors who invest in top performers canmake significant risk-adjusted returns even after the momentum effect is controlled, itsuggests that these investors are really smart and have undiscovered skills to earnabnormal returns.The test uses the complete universe of 9,607 diversified U.S. equity mutual funds for the period from January 1993 to September 2008 in the CRSP Survivor-Bias Free U.S.Mutual Fund Database. Similar to Zheng (1999), this paper starts with an examinationof GT measure (Grinblatt and Titman, 1993). This measure examines whether investors can profit by tilting their portfolio weights over time in favor of assets withhigher expected returns and away from assets with lower expected returns. The resultindicates that investors who put money in funds whose total net asset (TNA) are thelowest 20% can switch their money to funds with higher expected returns.  4 However, the GT measure is not implementable in practice because most funds forbidshort selling of their shares. Hence, I follow the methods in Zheng (1999) to construct8 trading strategies weighted by unexpected money flows (Coval and Stafford, 2007)and other 2 trading strategies based on the GT measure to observe whether risk-adjusted returns can be earned by following the trading strategies. Since the GTmeasure is significant only for funds whose TNA are the lowest 20%, i.e., the smallestfund group, I focus on this group to further investigate the practical implications of investor buying and selling decisions.The results of trading strategies suggest that the smart investors can be found in thetop performing funds. After I rank the smallest funds to quintiles by excess returns,only the fund group with top performance exhibits the significantly positiverisk-adjusted return and such outperformance cannot be eliminated by the inclusion of the momentum factor. That is, the risk-adjusted returns earned by investors who investin the winners cannot be explained by the momentum effect argued by Sapp andTiwari (2004). However, the trading strategies of the entire smallest fund group beforegrouping to quintiles do not exhibit the significant risk-adjusted returns over themarket. This suggests that the smart money effect would be diluted by usingunclassified observations, as I argued above. In addition, when using the accumulativeunexpected flows as weights, I find that the information of unexpected flows is lessinformative as time goes by, which means that the smart money effect is short-lived.The significant risk-adjusted returns and the short-lived phenomenon inspire aquestion: Why this intelligence of smart investors is short-lived? Since the behavior of flocking to the top performing funds itself is momentum, it is surprising to find thatthe risk-adjusted returns of the top performing fund group cannot be explained by the  5 momentum effect. Therefore, the smart investors must possess undiscovered skills todistinguish themselves from the momentum-style investors who simply chase fundsthat were recent winners.If both smart investors and momentum-style investors can identify superior funds andflock to them, the potential difference between smart investors and momentum-styleinvestors is when to buy or sell these superior funds, i.e., timing ability. When fund performance reverses, smart investors can make correct and immediate response whilethe momentum-style investors cannot. For example, if there is a fund which performsvery well from t+1 to t+12 , the smart investors who are able to recognize this will buyit in the beginning of  t+1 and sell it in the end of  t+12 . On the other hand, for themomentum-style investors who chase the winners based on past three-month returns,they can still identify this fund due to the momentum investing strategy. However,their momentum investing strategy would lead them to buy this fund in the beginningof  t+4 and sell it in the end of  t+15 . Under such situation, both smart investors andmomentum-style investors would invest in this fund from t+4 to t+12 but the smartinvestors would obtain higher returns than momentum-style investors do due to better timing ability. However, owing to the overlap of investment periods, it is possible thatsmart investors are misidentified as momentum-style investors when using all fundinvestors in the market to be the sample.The significant risk-adjusted returns earned by smart investors documented above provide us a good opportunity to examine whether the timing ability is thedeterminant of earning abnormal returns for smart investors. Therefore, I use the smartinvestors who are in the top performing fund group as the sample and follow themethods of Chen, Adams and Taffler (2009) to observe whether they have timing
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