Does Stock Return Momentum Explain the “Smart Money” Effect?

Does the “smart money” effect documented by Gruber (1996) and Zheng (1999) reflect fund selection ability of mutual fund investors? We examine the finding that investors are able to predict mutual fund performance and invest accordingly. We show that the smart money effect is explained by the stock return momentum phenomenon documented by Jegadeesh and Titman (1993). Further evidence suggests that investors do not select funds based on a momentum investing style, but rather simply chase funds that were recent winners. Our finding that a common factor in stock returns explains the smart money effect offers no affirmation of investor fund selection ability. Does Stock Return Momentum Explain the “Smart Money” Effect? Do investors make smart choices when selecting mutual funds? Studies by Gruber (1996) and Zheng (1999) suggest that investors have selection ability, a finding that has been dubbed the “smart money” effect. Using a sample of 227 stock mutual funds during the period 1985-1994, Gruber (1996) shows that the risk-adjusted return on new cash flows to funds is higher than the average return for all investors in the funds. Subsequent work by Zheng (1999) analyzes a sample of 1,826 stock mutual funds during the period 1970-1993 and also finds that the short-term performance of funds that experience positive new money flow is significantly better than those that experience negative new money flow. One possible explanation for the smart money effect is that investors base their investment decisions on fund-specific information, or in other words they have an ability to identify superior managers and invest accordingly. An important implication of such an interpretation is that it provides a rationale for investing in actively managed mutual funds, as argued by Gruber (1996). This is not, however, the only plausible explanation for the smart money effect. In particular, we note that in benchmarking fund performance neither Gruber nor Zheng accounts for the well-known Jegadeesh and Titman (1993) stock return momentum phenomenon. Carhart (1997) demonstrates that momentum is an important common factor in explaining stock returns. Furthermore, he shows that the previously documented evidence of persistence in mutual fund performance is not robust to the momentum factor. In light of Carhart’s findings, a natural question that arises is whether the smart money effect is really due to fund-specific information as suggested by Gruber (1996) and Zheng (1999), or whether it can be explained by exposure to momentum. Specifically, suppose that fund investors merely chase past performance. Then funds that happen to hold high concentrations of recent winner stocks would on average receive more investor cash while also benefiting more than other funds from the effects of return momentum. This, in turn, could lead to the finding of a smart money effect despite the absence of any ability on the part of investors to select superior fund managers.