Is Money Smart When Funds are Young?

DOIhttp://doi.org/10.1111/ajfs.12025
AuthorSungbin Cho,Inseok Shin
Published date01 August 2013
Date01 August 2013
Is Money Smart When Funds are Young?*
Sungbin Cho
Department of Economics, Soongsil University
Inseok Shin**
College of Business and Economics, Chung-Ang University
Received 17 February 2012; Accepted 28 March 2013
Abstract
Researchers have explored whether fund flows can predict future fund performance with
mixed results. We investigate the smart money effect in light of a rational agent model built
on Berk and Green (2004, Journal of Political Economy, 112). When investors infer the mana-
gerial abilities of funds from past fund returns, assuming partial adjustment, the model
implies that the smart money effect arises for young funds. Employing a Korean monthly
dataset, we establish a smart money effect for young funds but not for the whole fund
universe. Further analyses, however, indicate that the smart money effect lasts only one
month, and is driven by investment flows responding to public information including past
fund returns. The additional findings suggest that an alternative explanation based on
non-managerial characteristics, such as price pressure rather than superior managerial
performance, cannot be ruled out yet.
Keywords Smart money; Learning; Fund selection ability; Fund age
JEL Classification: G11, G14, G23
1. Introduction
Is money “smart”? Does new money in and out of funds forecast the future perfor-
mance of funds? The fund selection ability of investors has been an important
research topic in the fund industry, second only to fund performance. It has impli-
cations for investor rationality, efficiency of the fund industry, and thus, efficiency
of the modern financial market where the fund industry plays an increasingly
important role. A large body of literature has explored whether fund flows can pre-
*Acknowledgments: The authors gratefully acknowledge the financial support provided by the
IREC, the Institute of Finance and Banking of Graduate School of Business at Seoul National
University. We thank the editor (Chang-Soo Kim), the associate editor and anonymous refer-
ees for their valuable comments. All remaining errors are our own.
**Corresponding author: Inseok Shin, College of Business and Economics, Chung-Ang
University, 84 Heukseok-ro, Dongjak-gu, Seoul, Korea, 156-756. Tel: +82-2-820-5581, Fax:
+82-2-817-4891, email: ishin@cau.ac.kr.
Asia-Pacific Journal of Financial Studies (2013) 42, 590–626 doi:10.1111/ajfs.12025
590 ©2013 Korean Securities Association
dict future fund performance with mixed results. Gruber (1996) and Zheng (1999)
find evidence supporting the smart money effect in US quarterly data from the
1970s and 1980s. However, after controlling for the stock return momentum, Sapp
and Tiwari (2004) contend that the smart money effect no longer exists for US fund
flows. Recently, Keswani and Stolin (2008) reassert that the smart money effect
exists at least in post-1991 US data even after allowing for momentum. They also
document a robust smart money effect in UK data during the sample period of the
1990s.
While there is yet to be consensus on the predictive power of past fund flows
on future fund performance, what drives the smart money effect, if it exists at all,
remains equally controversial. Zheng (1999) conjectures that the smart money effect
is driven by small fund investors with fund-specific information. Wermers (2003)
and Lou (2009) suggest another possibility. They argue that new money flows are
disproportionately used by funds to buy stocks that they already own, exerting an
upward pressure on these stock prices, and thus driving the smart money effect.
Keswani and Stolin (2008) dismiss the price pressure explanation on the grounds
that outperformance lasts beyond the one-month mark.
As such, the current literature raises as many questions as it answers. Is money
really smart? Is the smart money effect time-dependent or limited to certain types
of funds? If so, then why? More importantly, can we theorize a source of the smart
money effect that is consistent with the various empirical results?
In this paper, we attempt to address these questions. We explicitly present a
model of investors’ fund selection processes in the first place. By employing a
clearly delineated theoretical underpinning, we aim to verify the presence of the
smart money effect, together with its underlying sources, more thoroughly. For a
model of the fund selection market, we build on Berk and Green (2004), who
provide a parsimonious rational model of active portfolio management and
fund selection, where rational investors and managers interact without either
behavioral effects or asymmetric information. Our goal is to see whether a small
adjustment of this standard rational agent model can generate the smart money
effect, and to evaluate how consistent the smart money effect predicted by the
model is with the data. We believe that it makes sense to first establish how far
a benchmark rational model can go in explaining the presence or absence of the
smart money effect, before appealing to market imperfections or behavioral
biases.
In its original setting, Berk and Green’s model has three main elements. First,
fund managers are capable of generating excess returns over a benchmark on aver-
age, but differ in their abilities and are subject to decreasing returns to scale in
deploying these abilities. Second, investors infer managerial ability from past
returns. Finally, fund flows by investors are competitive. Investors supply capit al
with infinite elasticity to funds that are expected to yield positive excess returns.
Regarding the flowperformance relationship, the model predicts that past fund
Is Money Smart When Funds are Young?
©2013 Korean Securities Association 591
performance leads to current fund flows due to investor learning. However, in the
model, no smart money effect exists; there is no relationship between current fund
flows and future fund performance because of the infinite elasticity assumption.
Because investors are assumed to move flows instantaneously without costs, in
equilibrium, current fund flows cannot predict future performance.
Obviously, the infinite elasticity of fund flows toward expected fund perfor-
mance is a simplistic assumption rather than a realistic one. We replace it with the
partial adjustment assumption. Owing to frictions such as transaction costs and/o r
liquidity constraints, investors cannot achieve the desired adjustment instanta-
neously when they want to increase or decrease their investment in funds. Instead,
adjustment of fund flows can occur only over a certain amount of time. In the
presence of partial adjustment, the smart money effect emerges. When investors’
learning from past returns indicates positive excess expected returns for a group of
funds, current fund flows into these funds will predict a positive future perfor-
mance of the funds until adjustment is completed.
From our observations, we obtain testable implications of the model. For young
funds for which learning is yet to be completed, the current fund flows predict
future fund performance, resulting in the smart money effect. However, the smart
money effect will not be found for old funds for which managerial abilities are
already known to investors. We test the predictions of the model, using the Korean
monthly dataset from May 2002 to April 2010. Following the smart money lite ra-
ture (Zheng, 1999; Sapp and Tiwari, 2004; Keswani and Stolin, 2008), we form new
money portfolios of funds based on fund flows. Investigating the one-month-ahead
performance of the portfolios, we find that high new money portfolios consisting of
young funds outperform benchmark returns. In contrast, such outperformance over
benchmark returns is not found in other groups of funds. To check the robustness
of the findings, we implement a cross-sectional regression instead of the new money
portfolio approach and discover that fund flows conditioned on age indeed predict
future fund performance.
Having found the existence of the smart money effect in the young funds group,
we examine whether investors make use of private as well as public information,
including past returns, to detect superior future fund performance and direct
investment flows. We find that investment flows, which lead to the smart money
effect, are driven by public information only. Moreover, we find that the smart
money effect lasts only one month. Given that investors rely on readily available
public information only and that the smart money effect is short-lived, it may be
legitimate to ask if the smart money effect found in the young funds group is actu-
ally due to investors’ rationally maximizing behavior in a fund market populated by
managers with various managerial abilities. We consider an alternative channel that
might result in the smart money effect for young funds, but not for old funds:
investors’ return-chasing behavior and price pressure. We find some indicative evi-
dence for the alternative, though a final verification is beyond the scope of this
paper.
S. Cho and I. Shin
592 ©2013 Korean Securities Association

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