People tend to call it smart money but as I have argued before, investing success has little to do with intelligence. So, when I saw a new study that investigated which investors take the right and wrong side of specific trades, I was cringing a bit at their use of the term “smart money”. But apart from that, this new study by David McLean and his colleagues is definitely worthwhile to read.
What these academics did was to investigate how different investor types positioned their portfolios in stocks that show specific anomalies. There is an entire zoo of different investment anomalies or factors that have been associated with significant outperformance vs. a market benchmark. Some of these anomalies require investors to buy stocks, other anomalies require investors to short stocks. McLean and his colleagues looked at 130 of these anomalies and then investigated how different investor groups from retail investors to hedge funds positioned their portfolios with respect to these anomalies. Because knowing these anomalies and trading on them requires a certain level of education (i.e. knowledge about prior research that identified these anomalies), I like to call investors that exploit these anomalies the “educated money”, rather than the smart money.
A key result of the study is shown below. It shows how portfolio positions in stocks that would eventually become anomaly shorts or anomaly longs changed by investor group in the year before. For example, retail investors on average increased their positions in stocks that exhibit anomalies that should be shorted by 0.1% in the year before. So they ended up on the wrong side of the trade, on average. On the other hand, they reduced their positions in stocks that should be bought by 0.02%. Again, they ended up on the wrong side of the trade. Retail investors are clearly the uneducated money in the market.
Interestingly, mutual funds, banks, and insurance companies all tended to sell stocks on average that should be sold, but also on average sold stocks that should be bought. So, in the end, while they tend to be good at selling stocks, they tend to be poor at buying the right stocks and as a result, they don’t benefit much from stock market anomalies. Hedge funds are the opposite. They built positions in stocks that should be bought but also in stocks that should be sold, again reducing their net benefit from stock market anomalies.
The only investor group that did the right thing on both sides of the trade and thus the educated money in the market are short sellers. On average, they shorted stocks that should be shorted and bought stocks (or in this case, reduced shorts) that should be bought.
No wonder then that short sellers tended to benefit the most in their performance from stock market anomalies while hedge funds, mutual funds, and other institutional investors tended to neither benefit nor lose from these anomalies. Retail investors, on the other hand, tend to reduce their performance by trading against stock market anomalies.
This shows that retail investors can simply enhance their performance by educating themselves about stock market anomalies and then positioning their performance in line with these anomalies. And even professional investors at mutual funds, banks and insurances could simply improve their performance by paying more attention to these anomalies when they buy stocks.
Changes in portfolio positions of stocks that benefit from long anomalies and short anomalies in the year before
Source: McLean et al. (2020).