Is Money in Index Funds Smart?

Abstract

Passive funds with inflows generate positive risk-adjusted returns during the subsequent year and outperform funds with outflows, consistent with the notion that index fund money is “smart.” Similar outperformance during the next year is not present in active funds seeing higher inflows. Passive funds that outperform see high inflows even though their performance does not persist after accounting for size, value, and momentum. These findings suggest that the “smart money” effect in passive funds reflects genuine investor ability, where unexpected flows outperform, and is not driven by the expected flows associated with naïve trend chasing or by price pressure effects.

Keywords: index funds, smart money, investor sophistication

JEL Classification: G11, G23