What Drives the 'Smart-Money' Effect? Evidence from Investors' Money Flow to Mutual Fund Classes

Abstract

The literature proposes two competing explanations — the “smart-money” and “persistent-flow” hypotheses — for the positive relation between mutual fund flow and future fund performance. We examine the flow-performance relation for different classes of U.S. domestic equity mutual funds. Our results show a stronger positive relation for the retail class than for the institutional class. More importantly, the significant relation for the retail class is mainly driven by funds with net outflow. This evidence is inconsistent with the smart-money hypothesis. We further show that retail funds exhibit greater persistence than institutional funds in net outflow. Once we control for expected fund flows, the flow-performance relation is no longer significant. We also perform robustness checks based on international funds and bond funds. The findings are supportive of the persistent-flow explanation.

Keywords: Fund Flows, Smart-Money Effect, Persistent-Flow Explanation, Institutional Funds, Retail Funds, Fund Classes

JEL Classification: G10, G11, G14, G23