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The Markovian Dynamics of "Smart Money"

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  • J-H Steffi Yang

Abstract

I develop a Markov model of samrt money chasing past winning funds while taking into account associated costs. The model also allows market capital entry and exit. The steady-state capital allocations re derived using constant transition probabilities. The results sugget that down side risk is significantly attributed to investor overreactoin, even though a small degree of investment movement as opposed to capital immobility can in fact stabilize the market. Furthermore, performance sensitivity makes it possible that two much-debated fund styles, passive indexing and active management, are simultaneously profitable. If money is insensitive, the model becomes a zero-sum game where one strategy's profitability is always at the cost of the other

Suggested Citation

  • J-H Steffi Yang, 2004. "The Markovian Dynamics of "Smart Money"," Econometric Society 2004 Far Eastern Meetings 797, Econometric Society.
  • Handle: RePEc:ecm:feam04:797
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    File URL: http://repec.org/esFEAM04/up.11840.1086268553.pdf
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    References listed on IDEAS

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    1. Grinblatt, Mark & Titman, Sheridan, 1993. "Performance Measurement without Benchmarks: An Examination of Mutual Fund Returns," The Journal of Business, University of Chicago Press, vol. 66(1), pages 47-68, January.
    2. Chevalier, Judith & Ellison, Glenn, 1997. "Risk Taking by Mutual Funds as a Response to Incentives," Journal of Political Economy, University of Chicago Press, vol. 105(6), pages 1167-1200, December.
    3. Lu Zheng, 1999. "Is Money Smart? A Study of Mutual Fund Investors' Fund Selection Ability," Journal of Finance, American Finance Association, vol. 54(3), pages 901-933, June.
    4. Grinblatt, Mark & Titman, Sheridan D, 1989. "Mutual Fund Performance: An Analysis of Quarterly Portfolio Holdings," The Journal of Business, University of Chicago Press, vol. 62(3), pages 393-416, July.
    5. Brown, Stephen J & Goetzmann, William N, 1995. " Performance Persistence," Journal of Finance, American Finance Association, vol. 50(2), pages 679-698, June.
    6. Alessio Sancetta & Steve Satchell, 2004. "Calculating hedge fund risk: the draw down and the maximum draw down," Applied Mathematical Finance, Taylor & Francis Journals, vol. 11(3), pages 259-282.
    7. Judith Chevalier & Glenn Ellison, 1999. "Are Some Mutual Fund Managers Better Than Others? Cross-Sectional Patterns in Behavior and Performance," Journal of Finance, American Finance Association, vol. 54(3), pages 875-899, June.
    8. Carhart, Mark M, 1997. " On Persistence in Mutual Fund Performance," Journal of Finance, American Finance Association, vol. 52(1), pages 57-82, March.
    9. J.-H. Steffi Yang & Satchell, S.E., 2002. "The Impact of Technical Analysis on Asset Price Dynamics," Cambridge Working Papers in Economics 0219, Faculty of Economics, University of Cambridge.
    10. Erik R. Sirri & Peter Tufano, 1998. "Costly Search and Mutual Fund Flows," Journal of Finance, American Finance Association, vol. 53(5), pages 1589-1622, October.
    11. Grinblatt, Mark & Titman, Sheridan & Wermers, Russ, 1995. "Momentum Investment Strategies, Portfolio Performance, and Herding: A Study of Mutual Fund Behavior," American Economic Review, American Economic Association, vol. 85(5), pages 1088-1105, December.
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    More about this item

    Keywords

    markov model; fund styles; drawdown; capital movement;

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors

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