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The Risk of Hedge Fund Herding and its Role in Today's Financial Markets

Aug 15, 2017

Over the past several decades, hedge funds have grown from a niche investment to a key asset management tool for institutional investors around the world. Since 1997, hedge assets under management have skyrocketed from $118 billion to nearly $3 trillion.  In recent years however, “herding” has become more common in the industry, posing increasing risks for investors. Specifically, hedge fund “groupthink” reflects managers chasing too few ideas and finding little to no success when an investment fails for multiple funds.  While hedge fund managers research possible investments, outside information can be just as influential. Fund managers find themselves receiving information among their peers at various networking events, and may use certain ideas to make certain investment choices. This type of information influence can be referred to as informational cascade. As hedge fund herding remains a reoccurring issue, it will continue to adversely affect the financial industry.

Herding became a term linked to market downturns such as the bursting of the dotcom bubble of the late 1990s and the financial crisis of 2008. Essentially, herding is a mentality characterized by minimal individual decision-making, resulting in fund managers thinking and acting as their peers. From a psychological standpoint, the study of observable human behavior, also referred to as behavioral theory, supplements why herding may occur. People learn to respond to particular situations through observing others and viewing those people as models for imitation and guidance. Common models are those who are seen as successful and are rewarded individuals. These models can be used for two types of herding: intentional and unintentional herding. Intentional herding refers to the common situation where managers are aware of the popularity of his or her stock pick. Essentially, those who intentionally herd consciously follow the crowd. In contrast, many fund managers also find themselves unintentionally herding, or investing in the same stocks as others with no prior agenda. Though there are distinct definitions between intentional and unintentional herding, there is no definitive way to differentiate between the two forms of herding. It is easy to merely accept intentional herding as the reason for fund managers investing in similar stocks, but there are situations where the herding is purely unintentional.

All hedge fund managers have access to publicly available information, but research and analysis internal to a firm also influences decision making. When a fund manager makes a decision, it often starts a ripple effect of knowledge that travels from person to person. Their choices, in addition to their own personal knowledge and inferences, inevitably and unintentionally influence the decision making of fund managers to come. The name for this trickling information signal is called informational cascade. An informational cascade can be illustrated by a simple example: An average individual assumes, unlike himself, a financial specialist has a calculated understanding of stocks. As a result, the individual imitates the specialist’s investment decisions. A friend of the average individual observes him boasting about his successful stock picks and by making the same initial assumption as the average individual, the friend ultimately decides to invest in the same stocks. The pattern will continue to spread from person to person. This cause and effect is a blind trust of information and essentially starts the informational cascade. Overall, the flow of private knowledge from person to person, whether the recipient knows it or not, influences that individual’s decision making. When fund managers are unaware of their participation in the cascade their actions can resemble intentional herding. In truth managers are unintentionally herding as a result of their decisions trickling down from someone else’s previous investment decisions.

As the competition to meet client demands has become fierce, the industry has developed to the point where fund managers have immense pressure to retain clientele and to deliver on clients’ return expectations. The competition throughout the industry has also sparked competition amongst fund managers within their own firms, driving managers to work towards minimizing their blame for company return on investment.  This results in a great deal of fund managers finding themselves uncertain in their skills and fearful of tarnishing their reputations. This risk-averse mentality, which many managers are similarly victims of, is an outgrowth of the fear of reputation risk. They become more reliant on what they are accustomed to investing in and look for investments that offer certainty. Many fund managers invest in specific stocks and securities that fill the previously stated requirements only to find many other managers using the same strategy. While this may seem like herding, their unintentional mentality and similar situations ultimately force managers to invest in the same types of available stocks and securities.

Fund managers should consider the long-term risks and consequences of herding.  A few of the risks can be observed during the burst of the dotcom bubble in the 1990s, as it was the result of excessive investment in online retailing and tech stocks. NASDAQ tech stocks grew from around 1,000 points in 1995 to more than 5,000 in 2000, but by April of 2000 nearly a trillion dollars’ worth of stock value was gone.  The rush of investments in the same stocks resembles the theory of informational cascade. In the event a fund manager in an informational cascade loses money, everyone in that herd follows with the same losses. When herding occurs, the majority has taken the same position and direction in the market, resulting in there being no one left to push trends any further.  Therefore, as the herd grows, the risk for a financial crisis increases exponentially.

Transitioning into a great digital age in today’s markets, another risk has also emerged. Artificial intelligence poses a risk to fund managers, as a result of robots being able to complete the same tasks humans are currently completing, but without human biases and sensitivities. If herding continues, it might put fund managers at an even greater risk of replacement. Therefore, intentional or not, herding remains a hurdle in the financial industry, and finding possible solutions for the problem is an integral part of preventing future investment risks and catastrophes from arising.

Asset Management Intelligence – Q3 2017

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Garth Puchert

Garth Puchert, Audit Partner of EisnerAmper's Financial Services Group, is primarily devoted to private equity funds, registered investment companies, investment advisors, mutual funds, hedge funds and broker-dealers in securities.

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