Smart Money or Smart about Money? Evidence from Hedge Funds

Abstract:     
This paper introduces a measure of fund-flow impact, based on a fund's contemporaneous return-flow relation, and demonstrates that the smart-money phenomenon predominantly stems from high-flow-impact funds. A smarter-money strategy, one that concentrates in high-flow-impact funds, fares significantly better than a strategy which concentrates in low-flow-impact funds and earns a premium of 6.5% annually over 1999-2008, after controlling for various risk factors and trading restrictions. Although the effect is strongly apparent for outflows, the analysis shows that a smarter-money-conscious long-only-investment portfolio significantly outperforms the hedge-fund index. The paper suggests that the smart-money effect is not necessarily indicative of superior investor ability to predict manager skill, but rather may reflect the ability of some investors to predict the behavior of other investors whose flow affects fund return.

Keywords: Hedge funds, Fund flows, Smart money, Asset pricing, Flow impact

JEL Classifications: G12, G14

Working Paper Series