Crowdsourcing investments: it’s all about chosing the ‘right crowd’

We’ve spoken a lot about piggyback investing (mimicking the moves of top fund managers) and crowdsourcing ideas (using crowd sentiment to generate trading ideas) as two ‘new ways’ investors can devise profitable strategies.  The Internet is producing tons of information – the tradestream – that investors can plug into to get at this type of data.

But investors keep asking me, “Well, who do we follow?”  And they’re right – the Web continues to provide more and more insight into the daily trading activities of some of the brightest performers but with this onslaught of informational smog, we’re still left with the decision of who to track, who to follow, which crowd to source.  In Surowiecki’s book, in fact, he delves into the difference between smart crowds and not-so-smart crowds. 

TrimTab is one of the leading providers of capital flow information around which it creates trading strategies.  Last week the firm published a whitepaper (.pdf) outlining a contrarian ETF strategy that makes use of this aggregate data and actually bets against the dumb-money — in this case, the average retail investor.

In “Using Equity ETF Flows as a Contrary Leading Indicator” (.pdf), TrimTabs found the following:

  • Monthly  equity  ETF  flows  (as  a  percentage  of  assets)  and  the  returns  of  the  S&P  500  one  month  later  are negatively correlated to the tune of 21.4%. 
  • The  negative  correlation  rises  to  45.6%  for  a  two-month  period,  and  to  52.4%  for  a  three-month  period.  

With this in hand, the research firm created a system that goes long the S&P when money is flowing out of ETFs and sells it when money is moving in.  The results are amazing:

trimtabsperformance

The researchers suspect 2 reasons behind this performance:

  1. they believe that ETFs are typically really liquid and used primarily by retail investors whom TrimTabs believes are the least-well informed investors out there. Or better put, the ETF liquidity “allows investors to make poor decisions any time of day.” Or, as MarketWatch put it, “Simply put, ETF investors are impressively wrong in both directions.”
  2. hedge funds trade ETFs when liquidity dries up in individual stocks. 

Whether this works or not or is just backtested data (it works until it doesn’t), I don’t  know.  But it does drive home the importance of following the ‘right’ crowd or the right guru.  Otherwise, we are just part of the investing noise, not rising above it.