Hedge fund managers' over-reliance on information gleaned from a small group of trusted contacts in other hedge funds exposes them to financial risk, according to new research.
The paper by LSE, IESE Business School and the University of Essex shows that hedge fund managers tend to turn to small, cohesive networks made up of competing fund managers to compare and test initial trading ideas and to look for potential flaws in their planned investment strategies.
These networks, where like-minded people circulate a limited set of ideas, increase the likelihood of consensus trades and their associated risks according to the researchers.
Dr Yuval Millo, a lecturer in Accounting at LSE specialising in the sociology of financial markets and one of the authors of the paper, said: "These networks are not necessarily a negative thing but they are an amplifying mechanism. They increase the likelihood that a group of hedge funds can all head off in a wrong direction with an investment idea. And we found that this is not just a fringe phenomenon. There is enough of it going on to make the market vulnerable."
The researchers observed that hedge fund managers usually spoke several times a day with one or more of their network friends. The information gained from sharing ideas, views and market positions clearly out-weighed the exposure of communicating with competitors. Communication continued throughout the investment decision-making cycle.
The networks are bound together by trust and reciprocity. All the hedge fund managers the researchers looked at had worked in a previous job with at least one other person from the group, often on the same trading desk.
However reliance on their own networks can mean that hedge funds may 'lock in' on an investment idea and ignore warning signs. For example, the researchers found that prior to investing, the fund managers had extensively discussed within their networks the VW-Porsche trade – a trade that went badly wrong in 2008. But, they did not take into account relevant information from brokers and analysts.
This led to hedge funds losing an estimated £18 – £24 billion when they short traded Volkswagen(VW) shares – gambling that the company's share price would fall. Instead, Porsche revealed it had secured control of over 75 per cent of VW's stock. VW's share price soared as Funds who needed to buy back shares to close their short positions rushed to buy the remaining stock.
Dr Millo said: " The hedge funds' social networks did not cause the crisis but they certainly increased its impact. This wasn't just one or two hedge-funds making the wrong decisions – this was one of the largest losses on a single company's shares ever taken by hedge funds."
The research is the first to analyse in detail the social structures and practices through which investment decisions are made in hedge funds.
Between December 2007 and June 2009 the researchers interviewed 60 hedge fund managers, brokers, analysts and traders from 26 hedge funds and 8 brokerage firms in Europe, the United States and Asia. They conducted fieldwork in 10 of these hedge funds and brokerage firms.
The hedge funds analysed by the researchers controlled 15 per cent of all assets managed by hedge funds.
The research was conducted by Jan Simon (IESE Business School), Yuval Millo and Ofer Engel (London School of Economics and Political Science) and Neil Kellard (University of Essex).
Posted Friday 17 February 2012
An electronic copy of the paper 'Close connections: Hedge Funds, Brokers and the Emergence of a Consensus Trade' is available to journalists from the LSE press office
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