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Dumb Individual Investors and Smart Companies?

| | Posted in: Buybacks-Secondaries, Mutual/Hedge Funds

In their April 2005 paper entitled “Dumb money: Mutual Fund Flows and the Cross-section of Stock Returns”, Andrea Frazzini and Owen Lamont tackle a range of analyses tied to mutual fund inflows and outflows to determine whether or not these flows represent rational behavior on the part of individual investors. Do the flows predict abnormal returns for the underlying stocks? What do they mean for the wealth of the individuals causing them? By studying flows associated with domestic mutual funds from 1980 to 2003, they find that:

  • High individual investor sentiment, as measured indirectly via mutual fund flows, predicts low long-term future returns for underlying stocks. Stocks owned by funds with large inflows tend to be overpriced.
  • In the long run, retail investors reduce their wealth by continually reallocating resources across different mutual funds. By chasing high mutual fund returns, they tend to direct their money to funds which invest in stocks with low long-term future returns.
  • This dumb money effect, present for both large and small capitalization stocks, is strongly related to the value effect. On average, money flows into mutual funds that hold growth stocks, and flows out of mutual funds that hold value stocks.
  • There may be short-term benefits to reallocations, but individual investors typically do not capture these benefits.
  • Public companies tend to take advantage of flow-driven demand for their stocks by issuing or buying back stock.
  • The dumb money effect tends to obscure differences in skill level among mutual fund managers.

In summary, mutual funds may function mostly as passive vehicles through which active individual investors (reallocators) voluntarily transfer wealth to public corporations. By doing the opposite of these individuals, one can construct a portfolio with high returns. By ceasing reallocations, mutual fund investors in aggregate could boost their Sharpe ratio by 9%.

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