Can You Follow the ‘Smart Money’?

Investors in the share market are often broken into categories of professional investors or ‘smart money’, and retail investors, being the mum and dad investors, who are often called ‘dumb money’. We went on a quest to see if it was possible to look at the difference between the two groups and how they traded. We found that there wasn’t a lot of difference between the two groups, which supports our anecdotal evidence over the past two decades.

Smart Money is not Always Smarter

If Smart Money is managed by full time investors, then the S&P Active Vs. Passive (‘SPiVA’) reports, show that most fund managers underperform after their fees are covered. Even before fees, a lot of managers still underperform.

That would imply that Smart Money is not always smarter than the market.

Anecdotally - Looking at professional managers out of the CV-19 lows of March 2020, a lot of managers remained largely invested in cash, waiting for the ‘second wave’ of cases to hit, terrible economic data to be announced, and the market to crumble.

While we are currently in a volatile bear market, being so heavily invested in cash has meant missing 30%-40% rallies in developed markets across the globe, which has led to massive underperformance – not a smart move.

Dumb Money is not always Dumb, but instead, inexperienced

Dumb Money is ‘supposed’ to invest incorrectly most of the time.

'Incorrectly' is summarised as buying at the highs and selling at the lows. We’ve all done this at times, it’s not an exclusive club for retail-only investors as professional managers are in that boat too.

We’ve seen professional managers steadfastly, and publicly, refute that companies like Telstra (TLS) or Myer (MYR) would lose their sparkle; stating that any dip should be bought and one should cling to the mast of the ship even as it’s taking on lots of water.

Anecdotally - I know retail clients, mum and dad investors, who have killed it with their investing, year after year; often returning more than 100% on their money for consecutive years. These are teachers, engineers and investors with normal day jobs. These investors started off the same as most people; they lost money and made mistakes. The key difference was that these investors spent much more time learning from their mistakes than they did looking for the next best trade. Interestingly enough, that’s what a lot of very successful and consistent professional traders talk about spending their time on too.

If dumb money and smart money both make mistakes with investing, then it’s not the mistakes that separate the two groups, but how they learn from the mistakes that makes the difference.

Blunt Instruments show Smart and Dumb money flowing together

To explore ‘how dumb the dumb money was’, we looked at the extreme instruments available to retail investors to invest in, in bullish and bearish times. The two blunt instruments we studies are two ETFs from Betashares.

GEAR - Called GEAR, from the description of gearing into the market through borrowed, or leveraged money. Investors buy GEAR when they believe there is an imminent market rise ahead. As this instrument is an ETF, there is no loan required to buy the ETF, just buy the units like you do any other share on the ASX.

BBOZ – This is a geared Bearish ETF that does the opposite to GEAR. One would buy this ETF if you thought the market was going down, as that’s when BBOZ makes money for investors.

These two ETFs are pure and simple. You buy GEAR when you think the market will go higher and BBOZ when you think the market will go lower. Generally, if your opinion about the market changes from either one of these bullish or bearish states, then you quickly sell GEAR or BBOZ. These are not ETFs that one leaves in the portfolio unattended.

Follow the Money Trail

Thanks to Betashares, for our studies, we were able to track the money going in and out of these funds since they listed on the ASX.

We then plotted the spikes in volume for the two ETFs to see when investors were running in and out of the ETFs.

• As with most investments, retail investors move with a trend and progressively their numbers increase.

• Retail investor’s footprints are like Bondi Beach after a busy summer’s day; you can’t track one person’s footprints, but you can see where the crowd has been walking.

• While professional managers move with trends too, their footprints are easier to follow because of their increased trade size. The large trades mean their movements stick out, more like the footprints of an elephant walking in mud.

If dumb money was dumb

When we compare the increase and decrease of investors in GEAR and BBOZ, the theory of Dumb Money would imply that:

1) Market tops are signalled by:

a. Lots of retail investors buying GEAR at the top of the market (being the green line peaking as the dark blue line peaks); and

b. Retail investors having abandoned BBOZ at the market top, just before it crashes down

2) Market bottoms are signalled by:

a. Retail investors having abandoned GEAR, just before the market takes off; and

b. BBOZ having the most number of investors right at the bottom

If Dumb Money does buy at the highs and sell at the lows, then the above statements would be true.

The charts shows that this happens almost as much as it doesn’t - which is what we’d expect in a free and open market.

What the Numbers Tell us

Below is a chart that plots the popularity of BBOZ and GEAR through the amount invested in these ETFs, or their Net Asset Values (‘NAV’). We plotted the NAV compared to the NAV’s 200-day averages. This way we could monitor whether the money trends were increasing or decreasing. This also removed the underlying trend that many more investors were using these ETFs as the years went on because today, both ETFs have much more NAV than four years ago.

• The red bar chart is the popularity of BBOZ

• The green line is the popularity of GEAR

• The dark blue line is the S&P ASX200 (XJO) showing how the Australian market performed

The chart shows mixed signals as to whether ‘dumb money’ is actually dumb and makes bad decisions or not. The mixed signals on the chart below, going left to right:

Bad: In March 2016 (light blue circle and line on chart), the red bar chart showed that BBOZ was popular and well above the 200-day average. This showed that investors were actively increasing their bearish positions. The dark blue line shows that bearish investors were wrong here, as the market started to climb.

Good: in March 2016 the light blue line showing the green chart increasing represents more bullish investors. This proved to be a good decision as the XJO kept rising for the next few months. Here bullish investors were right.

Bad: July 2016, the orange circle and orange line show that investors were very bullish and buying a lot of GEAR just as the market started to fall along the orange line.

Bad: March 2018, the purple circle and line show that investors were at their lowest bullish levels right as the market started to rise up the purple line. As the market rose, investors' bullishness rose too. However, the bullishness of investors peaked just after the market started to fall again. On a positive note, the bearishness of the market was rather low before this rally started.

Good: December 2018, the brown diamond and line show that the bearishness of investors was very low in the red bar chart, showing BBOZ was unpopular. However, this popularity of BBOZ peaked just after the lows, as the market started to climb up the brown line.

· Note how the green chart is also at its lows just as the market starts to climb the brown line.

Good: In July 2019 Bullish investors started to leave the market in the red box. The popularity of GEAR on the green line in the red box peaks and investors reduce their bullishness. While the market rises later in the year, GEAR investors are not lured into the market.

· Note that the red bar chart of BBOZ un-popularity is also turning in the lime green box.

Good: The market grinds up to highs before entering into the COVID drop on 2020 on the lime green box. Investors have been fleeing GEAR whose popularity was at a low just before CV19 hit. Meanwhile bearish investors have been growing in numbers and ride this CV19 wave down.

· The bearishness of the market peaks a month or so after the low. The popularity of both BBOZ and GEAR were on the right side going into the CV19 movement. Although investors have stayed too bearish as the market has climbed out of CV19 to July 2020.