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 embedded 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 portfolio selections around risk factors.

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

Fundamental trading is associated with the selection of risk factors, while changes in risk factors are associated with idiosyncratic risk or factor timing. Smarter money can factor in time and focus on idiosyncratic risk, while less sophisticated traders, with limited information-processing capacity, focus on factor selection. Hedge funds seem 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. Less skilled traders will focus on factor selection or fundamentals, not the transitory shocks in risk factors. 

Traders need to use information about risk factors to solve two types of uncertainty: the average payoff of a risk factor and its transitory or idiosyncratic portion. Attention to detail when processing information about any risk factor will determine whether a trader is a timer or a 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.