On Wall Street, there’s smart money and dumb money. You (and I) are dumb money. Smart money (big-time hedge-fund managers, private-equity honchos, leveraged buyout kings) reliably outperforms the market. Dumb money (individual investors, the sort of people who casually watch CNBC for stock tips) generally fares poorly. Individual investors—that is, we—are considered such dumb money that many professional investors regard us as contrary indicators. The lemminglike masses get excited and overly optimistic when the market’s about to top, and they tend to get fearful and overly pessimistic when the market’s about to bottom. So, if you could just figure out what the dumb money is doing and zig when it zags, that may be a path to easy profits.
Now a new working paper by two economists, Andrea Frazzini of the University of Chicago Graduate School of Business and Owen Lamont of the Yale School of Management, offers an excellent case study of dumbness: our incompetent investment in mutual funds. The paper also implicitly suggests how we can fix our own mistakes.
In theory, if investors picked and chose carefully from among the thousands of fund managers to place their money with great long-term stewards, then “flows should be positively correlated with future returns.” But as a class, mutual-fund investors are short-term return-chasers. If a fund puts up good numbers for a few quarters, it will attract lots of new cash. “Individuals tend to transfer money from funds with low recent returns to funds with high recent returns,” they note. In 1999, when Fidelity’s complex of funds was three times larger than that of technology-heavy Janus, investors plunged $37 billion into Janus funds and only $16 billion into Fidelity funds. That proved to be disastrous, since both Janus’ mutual funds and the tech stocks they bought did poorly in the ensuing years.
Lamont and Frazzini examined mutual-fund inflows from 1980 to 2003. Next, they devised a method of figuring out which stocks received disproportionate shares of the new money flowing into comparatively hot mutual funds. Stocks like Cisco, for example, found themselves with an abnormally high concentration of mutual-fund ownership in the late 1990s. By comparison, stocks in sectors that were unloved received less than their fair share of mutual-fund cash.
The short-term excess investment leads to long-term underperformance. Why? Suppose a tech-stock manager overweighted Cisco in the 1990s. That was smart, since Cisco rose massively. Next, individual investors began flocking to his fund and pouring money into it. The manager found himself with lots of new cash to put to work. So, what did he do? He bought more Cisco, at much higher prices. “When the manager of a tech fund experiences large inflows, his job is to buy more technology stocks, even if he thinks the tech sector is overvalued,” according to the paper. And as a result, mutual-fund managers wound up putting a lot of money into high-flying stocks at or near their tops and avoided putting cash into beaten-down stocks that were at or near their lows. That sort of behavior is a recipe for poor long-term returns. The high-flyers fell—and brought the funds down with them.
When they crunched the numbers, Lamont and Frazzini found that for every period longer than three months (and out to five years), the stocks receiving the highest flows of new mutual-fund money performed significantly worse than the stocks that received the lowest flows of new money. Over a three-year period, the difference was 8 percentage points a year. In other words, individual investors had lousy timing, and their efforts to chase returns ended up costing them dearly. As a result, the authors conclude that “individual investors in aggregate are unambiguously dumb.”
Ironically, this common-sense finding goes against conventional wisdom. Academic economists and traders have generally concluded that, in the short term, mutual-fund money is smart money. Money comes into mutual funds and is put to work in the market, the reasoning goes, so stocks tend to rise after inflows rise.
So, how can this knowledge help us make money? Do the opposite of whatever the mass of mutual-fund investors does. It takes some data-crunching. But a hedge fund or even a savvy individual who subscribes to the right services can compile mutual-fund inflow data, then download mutual funds’ public filings that show their holdings each quarter, then replicate Lamont and Frazzini’s calculations and figure out which stocks have been receiving lots of mutual-fund investment and which stocks haven’t. Just follow the money. Then go the other way.