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UI Study Examines Investors' Mutual Fund Selection Ability

Are investors really smart when it comes to picking the hottest mutual funds in the market? A University of Iowa study suggests that they are naively chasing past returns and only benefit from short-term gains.

Past research has shown that investors appear to pick superior performing fund managers and move into funds that perform well in the short run, while leaving funds that perform poorly over the same period. This finding has been dubbed the "smart money" effect.

Ashish Tiwari at the Tippie College of Business and Travis Sapp at Iowa State University looked at this perceived ability to choose the best funds in their paper "Does Stock Return Momentum Explain the 'Smart Money' Effect?," forthcoming in the Journal of Finance. The authors analyzed the flow of money into and out of stock mutual funds and examined whether the "smart money" effect can be attributed to investor fund selection ability, or if it has a simpler explanation.

In the study, Sapp and Tiwari examined cash flows of 5,882 U.S. stock mutual funds over the period from 1970 to 2000, but found no evidence of fund selection ability among fund investors. The study suggests that investors as a group don't identify skilled fund managers, but simply chase recent winners and unwittingly benefit from short-term momentum in the performance of stocks, leading to the appearance of "smart" fund investors.

Investors continue to favor picking actively managed funds, even though it's been shown that the average fund doesn't outperform an unmanaged index fund after expenses, Tiwari said.

"From a practical perspective, our findings serve as a cautionary tale for active investors who may be over-confident in their own selection abilities when choosing funds to invest in," Tiwari added. He suggested that low-cost index funds may be a better option for investors who don't want to risk holding the average actively managed fund that underperforms the market after expenses.


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