smart money dumb money

Smart money vs Dumb money: Positional perspective

The taxonomy of smart money vs dumb money implies that institutions such as funds are smart while retail traders and investors are dumb.

I beg to differ and I shall explain why in the following paragraphs. I will start with an overview of the two categories and some historical examples of devastating losses incurred by both groups.

What is Dumb money?

It’s me and you, dumb money and proud. I only have the capability of a single brain and I don’t have access to an army of analysts. Furthermore, I can’t move markets, pay higher fees compared to smart money and can’t code. Is this a handicap or an advantage?

I only know that no one was betting on David against Goliath. No one was betting on Netflix or Southwest Airlines for quite some time either. Just because someone is big and strong doesn’t necessarily mean that they are somehow superior and won’t go down in a heartbeat.

The advantage of dumb money is that you can do as you please. I’m not accountable to anyone but myself so I can close all my positions in about 5 minutes if I wanted to.

Notable Dumb money failures

1R0NYMAN

1R0NYMAN decided to implement an options strategy called a box spread in UVXY, a leveraged volatility product. A box spread can be either short or long. 1R0NYMAN decided to use a short box spread.

He received credit upfront because the options he sold were in the money (more expensive). The options he bought as a hedge were out of the money (cheaper).

This is a legitimate options arbitrage strategy. However, it is suitable for European style options (which can only be exercised on the day of expiration) and should ideally be cash-settled or at least allow contrarian instruction.

Unfortunately, he used the box with American style options (which allow early exercise) so he overlooked the risk of early assignment. The final result was a 2000% loss.

The KaloBios short squeeze

A trader decided to short sell $33,000 worth of KaloBios stock, a pharmaceutical company, at $2 per share which resulted in a loss of $106,000.

The problem was that he shorted a large number of shares of a low volume stock. Then the stock rose significantly after favourable news came out and his broker had to close the position at 800% loss.

CFDs and day trading

According to official statistics about 76% of CFD traders lose money, probably not life changing amounts but CFDs are notorious for losses and so is day trading.

This is not unusual as any high risk investment or trading activity is expected to have high failure rate. If you think about it start-ups are not that different. Hundreds of thousands of start-ups were set up in the UK last year.

How many of them are going to be the next unicorns? Not many, so why should the stock market be any different.

What is Smart money?

Knowledge

The notion of smart money comes from the perception that institutions have knowledge about the market that the rest of us do not. Smart money also have an army of very smart analysts, software engineers and mathematicians.

They can dig out any relevant piece of information and create sophisticated financial models. This brainpower allows them to allegedly outsmart the market and to position themselves to outperform.

Scale

Smart money have scale, supposedly they can buy or sell large number of shares and move a market to their advantage. They can purchase a whole company and change the operation as they wish.

Additionally, they can have significant voting rights and access to sell-side products unthinkable for the individual investor.

A zero-sum constraint

The zero-sum assumption is that if you make money someone else has to lose money. There is a perception of informational advantage on the smart money side which leads to the retail side ending on the wrong end of the trades.

This notion excludes the possibility that one of the two sides or both may have taken measures to hedge their positions. Nowadays, both institutions and retail clients can easily achieve this with derivatives.

Moreover, a lot of transactions are not zero-sum as purchase prices and time horizons vary significantly.

Notable Smart money failures

Long Term Capital Management

Long Term Capital Management was established in 1993 and had it all, a dream team: Scholes and Merton were on board. Yup, they later won a Nobel Prize in Economics for the The Black-Scholes-Merton option pricing model.

There was also Mullins Jr., former Vice chairman of the Federal reserve, two Harvard professors, Krasker and Hawkins, and multiple other experts.

This firm ended in 1998 with a bail-out by the Federal Reserve Bank of New York to the tune of $3.6bn. This was caused by excessive use of leverage and wiped out $1.9bn of the partners’ own funds.

Banks

Everyone has heard of Lehman Brothers and Bear Stearns, smart money investment banks which seized to exist in 2008. Some banks and other institutions were more fortunate and received a bail-out, here is a very long list.

It must be different in 2020

Luckin Coffee’s boss defaulted on a $500 million loan afforded to him by several banks which used company stock as collateral, the most notable include Morgan Stanley, Credit Suisse, Barclays and Goldman Sachs.

For reference, Luckin Coffee’s shares were trading at $30-40 per share in Q1 2020 compared to today’s price of $2.59. The steep decline was the result of fraud.

Even a unicorn company such as Wirecard is susceptible to committing what was described by Bloomberg as ‘the fraud of the century’ without any German lawmakers, regulators or institutional investors ever noticing.

Notable Mixed money failures

Oil futures turned negative

Unlike stock which can only go down to zero futures can turn negative, especially the ones which involve physical delivery, such as oil.

In this example a day trader purchased 212 oil futures contracts, each of them for 1000 barrels, at prices in the range of $0.01 – $3.30 per barrel.

Oil turned negative, however Interactive Brokers’ platform failed to display the negative price so it stayed at $0.01 instead. This trade resulted in a loss of $9 million, however Interactive Brokers had to foot the bill of $113 million.

Unlimited leverage

A retail trader decided to practice a bit on his broker’s demo platform. However, he did not realise that it wasn’t a demo and that Valbury Capital had authorised unlimited leverage on his 20,000 euro account.

He built a position with a notional value of $6.6 billion and actually realised a profit of $11 million from US index futures. The broker has not wired the profit even though they were the ones who gave him access to unlimited leverage.

Give the man his money after you deduct your fees, he made it fair and square!

Positional perspective

It seems that both smart money and dumb money can rack up eyewatering losses, sometimes in the billions. However, there seem to be cases when the interaction between the two groups results in outcomes which are no less astonishing.

I don’t see anything smart or dumb, just people who want to make money. However, I noticed that a lot of the failures on both sides and the two on the mixed side involve leveraged derivative products.

So we have established that excessive leverage is bad. We also established that the perceived informational advantage of smart money doesn’t prevent catastrophes. Then what is it? I will try to explain it via positional advantage.

The positional school of strategy

This is hands down my favourite view of strategy out of about 10 I am familiar with. The father of this line of thought is Michael Porter. He is best known for Porter’s five forces, an industry analysis strategic management framework.

In brief, it is meant to detect an industry’s specifics and to devise a strategy which allows the firm to position itself in such a way as to remain competitive.

Normally, you just identify how to secure competitive advantage, build barriers to entry which the competition cannot break and ensure that the product is not susceptible to any substitute products. It is easier said than done.

How does that work in real life

Everyone at some point in their life has made attempts to improve their position. You may have sought a promotion at work and you took the necessary measures to stand out. Or I decided to gamble a bit but wanted to improve the odds of winning so I played poker instead of roulette.

An internet giant may be involved in a lot of acquisitions of smaller companies before they are able to threaten it. Then a lost mountaineer may climb a hill to improve his or her visibility of the surrounding area. A fisherman may decide to go further away in the hope of more catch.

The examples of a positional strategy are ubiquitous in life, business and nature so it is not a meaningless academic construct.

What does this have to do with Smart money

Knowledge and experience

Actually quite a bit, in the same way as everywhere else institutions are better positioned to make money. I already mentioned the informational advantage.

All the smart people who work in institutions have dedicated years to study finance, math and the market among other things. You can’t expect to watch a few videos or go to a one day course and crack the market. It’s like me expecting to do better than my mechanic just because I have changed a few tyres in my lifetime.

Furthermore, they spend every day just doing that, they don’t trade only in their lunch break. There are a lot of problems in economics which exceed the cognitive capacity of any one person and require a team.

A group of people can see a problem from a few different angles and paint a cohesive picture of a given situation. It can also develop groupthink with disastrous consequences. So the team needs others to keep it in check.

Scale

Nowadays you can trade from £1. Therefore, if you realise 100% profit you’d end up with £2. Compare that to a £100 million pound fund which only needs to make 20% to earn £20 million.

Access

Smart money has access to capable people, technology, companies, industry peers and top management teams.

When is a sell-side investment bank going to call me to offer me an allotment in the latest IPO? Or when will I meet a Fortune 500 CEO? You guessed it right, never.

If you buy one share you get the mid-price if you’re lucky. If you buy millions of shares you can negotiate. But it’s not just that, institutions have access to variety of products, they are diversified and often hedged too.

Brokers earn money from your shares by lending them to short sellers and collect a premium.

Psychology

I never take the performance of a paper trading account too seriously. Oftentimes, it is difficult to replicate the success in a funded account.

The reason is that we behave differently when there is money at stake. The professionals always use paper money, metaphorically speaking, so they bypass a significant handicap.

I couldn’t find a link to the interview I read where an institutional trader said he’d never do that with his own money.

The dark side of Smart money’s position

Smart money wants you to be dumb. Who would pay high fees to an active investment fund if they just said they can’t outperform a low cost index fund in the biggest bull market of all time or during a market crash.

No one. Actually Dumb money beat them in the corona-crash aftermath.

Where do Smart money get the cash from

From all of us, it’s our money! People invest in active funds for various reasons, retirement and savings being the more popular ones. You put your money there and then wait for the smart people to do their thing.

Ok, but what about the sell-side (investment banks, market makers). They sell products to the buy-side (pension funds, hedge funds) so again it’s our money which is in circulation.

The Smart money’s Positional advantage

If I wanted to save for retirement in a tax efficient manner I can’t just go and buy an index fund. I’d need to use a specific type of account, a SIPP.

It is maintained by an institution and yes they will charge me because they are in the position to do so. If I was to find a low cost one, let’s say 0.3% per year I’d be getting a good deal right? I don’t know so I’ll calculate it.

Advantage over retail clients

If £100,000 are invested in a low cost SIPP as a lump sum for 30 years and nothing changes, so 0% return and 0.3% fees, I’d pay £8,619.24 in fees or an average of £287.31 per year.

That’s not that bad, charges are getting lower and lower. However, if the fees are slightly higher at 0.5%, the result is £465.39 per year. So some institutions collect a good amount of premium just to give you access to a pension.

Advantage over corporate clients

There are more opaque ways of making money. Investment banks are involved in the process of a company going public (IPO). It is a complicated and expensive endeavour but highly profitable for the banks involved.

This process is rarely open to the general public as people may buy the shares and then sell them on the first day of trading to realise 10% or more over a few weeks. This in turn may destabilise the share price which would force the investment bank to start purchasing shares.

An investment bank is not interested in doing this so sometimes there may be selling restrictions. It is mainly focused on the premium which is 4-7% of the value of the IPO.

It gets even darker

Financial innovation

Institutions often profit from financial innovation which usually involves complex over the counter derivative products. The most well known ones are interest rate swaps, credit default swaps and mortgage-backed securities, the latter popularised in The Big Short (2015) movie.

Such products are opaque, difficult to value accurately and have low liquidity, which creates the profit opportunity. Financial innovation is a bit of a special case because it lacks intellectual rights protection.

Therefore, the profit potential of the product declines once everyone finds out about it. This is due to an increase of the liquidity which makes the market more efficient.

Financial innovation is a complicated topic which deserves an article of its own: here is a detailed explanation for the more academically inclined.

Borrowing

Some hedge funds can access the Bank of England’s overnight lending facility, aka the repo-market. This is done with the sole purpose of speculating on the price of financial securities. It is not much different in the USA.

To put it simply some hedge funds have a margin account at the central bank!

Smart money vs Dumb money conclusion

Smart money are not necessarily that smart as institutions can lose money as quickly as their retail clients. The important takeaway is that a lot of the failures on both sides involve the excessive use of leverage.

Long Term Capital Management is a fantastic example that very smart people can lose an astounding amount of money by over-leveraging their positions.

Consequently, retail customers need to be careful when trading on margin. The last thing anyone wants is to end up in the papers over a stock market bet gone wrong.

Another important issue to consider is that institutions have a good position in the financial industry. It is the circulatory system of the economy so they are needed if we all want to have access to credit and to the stock market.

I feel that there should be more focus on understanding how retail investors and institutions interact. I don’t think that it is productive to dish out derogatory terms by calling people dumb.