Follow the smart money

Some analysts like to divide the market into “smart money” (investors who are able to spot opportunities before anybody else) and “dumb money” (those who put money into a company just when it is about to fall in price). The smart money is supposedly professional investors – such as fund managers – and the dumb money is ordinary retail investors. But do certain types of investors really perform better than others, and can you beat the market by following them?

The research that’s often used to support the argument that individuals are bad at picking shares is a 2000 study by Brad Barber and Terrance Odean of the University of California, Davis. Looking at the records of 87,000 clients of a brokerage firm from 1991-1997, they found the average client earned net returns of 16.7%, compared with 17.9% for the overall market. But it is important to note than the difference was down to trading costs. In fact, the investors’ gross performance (excluding costs) was higher than the market, suggesting that they were not bad stock-pickers.

However, while individuals are not necessarily bad stock-pickers, they are awful at timing the market (deciding when to invest). Financial research firm Dalbar has found that retail investors in US mutual funds badly lagged the S&P 500 over the three decades to the end of 2013, earning an annual average return of 3.7% against 11.1% for the market as a whole. While fees and expenses ate into returns, the big problem was that they tended to put money into funds that had peaked in value and sold their funds close to the bottom.

By contrast, there is evidence that professional investors are better at putting money into stocks. For example, Buhui Qiu of the Rotterdam School of Management found that, between 1982 and 2006, US shares that experienced the largest increase in institutional ownership subsequently outperformed the market. Other studies have found similar results elsewhere. Hongwei Chuang of Japan’s Tohoku University also found that in Taiwan between 2000 and 2014 increased institutional ownership boosted returns.

Both Qiu and Chuang’s studies find that a strategy that involved buying shares with the largest increase in institutional ownership would have earned higher returns than the market as a whole. However, before you blindly copy what funds are doing, you should bear in mind that both studies find that in the longer run the outperformance of each share diminishes, and even starts to reverse. This suggests that this “smart money” effect is due to herding and people copying each other – rather than fund managers being better at picking stocks.