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

TLDR

The smart money effect documented by Gruber (1996) and Zheng (1999) raises the question of whether mutual fund investors possess selection ability. We examine whether investors can predict mutual fund performance and invest accordingly. We find that the smart money effect is driven by stock return momentum, that investors chase recent winners rather than selecting funds based on momentum, and that this provides no evidence of fund selection ability.

Abstract

ABSTRACT 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 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.