Who represents smart money? Understanding who drives return performance

 

There will be talk about "smart" money and "dumb" money. Investors will talk about crowded trades. There will often be stories about groups of traders driving markets. The flows will matter. The dynamics of the market have been given a lot of press but there has been limited thinking about who profits from all this trading and the behaviors of different investors and how they process information. 

A recent paper tries to solve this problem. See "Which Investors Drive Factor Returns?" by Morad Elsaify. In this work, the author focuses on the processing of information as imbedded in the risk factors. The paper looks at a large set of risk factors and then measures the behavior of different trading groups around these factors. Different trading groups will show different portfolios selection around risk factors.

The processing of market information can come in two forms or choices: the persistent of fundamental risk factors or choice of risk factors, and the timing of idiosyncratic risk around a risk factor or factor timing. 

The fundamental trading is associated with the selection of risk factors while changes in risk factors is associated with idiosyncratic risk or factor timing. Smarter money will be able to factor time and focus on idiosyncratic risk while less sophisticated traders at processing information will focus on factor selection. Hedge funds seems to take more factor timing risk while more passive investors will focus on factor selection. Hedge funds will make markets efficient and act like arbitrageurs for factor returns. They will buy cheap factors and sell rich factors which will be idiosyncratic differences away from long-term averages. While those with less skill will just focus on factor selection or the fundamentals and not the transitory shocks in risk factors. 

Traders need to use information about the risk factors to solve two types of uncertainty, the average pay-off of a risk factor and the transitory or idiosyncratic portion of a risk factor. The attention or detail to processing information about any risk factor will determine whether a trader will be a timer or factor selector.

This not an easy paper to read, but it is highly suggestive of how information is processed by different trader types and provides a good explanation for what hedge funds do and how they behave.