Is Money Smart? - An Investigation of Mutual Fund Investor's Fund Selection Ability

Abstract

With $2.1 trillion assets invested in mutual funds, investors spend enormous time and effort on selecting funds. Do investors in aggregate display fund selection ability? Gruber (1996) finds evidence to support selection ability among active mutual fund investors. Using a large sample of equity funds, my paper closely examines this Smart Money effect to determine its economic significance, and the potential reasons why it exists. I evaluate the performance of trading strategies based on fund flows using risk-adjusted returns as well as a performance measure conditioned upon changing economic conditions. The performance measures clearly indicate that investors purchasing and selling decisions are able to predict funds future performance. However, the trading strategies suggest that it is difficult to make significant excess profits by following the herd. Thus there is some evidence that informed investors are able to outperform the average fund consistently. There is marginal evidence that investors can beat the market. What is the source of the Smart Money effect? An analysis using the Ferson and Schadt (1995) conditioning methods indicates that it is not due to responses to macro economic information, nor due to predictable style effects, but likely due to manager-specific information. This lends support to the regulatory policy of requiring broad disclosure of fund information, and suggests that investors, on average, act intelligently in making their share purchase decisions.