Theory

during the same time period. They document that the events of the 2008 financial crisis reduced hedge funds’ exposure to 40% of the total asset base of investment banks and 15% of the total asset base of the finance sector. They conclude that the exposure of the hedge fund industry to the finance sector before and especially after the financial crisis is modest compared to that of the listed financial intermediaries.¹³⁰

Herding occurs when financial institutions mimic other financial institutions while their own private information or proprietary models suggest different strategies.¹³⁵ This behavior in financial markets occurs because of the asymmetric information among traders or investors when trade is sequential. Although the standard economic theory, based on the efficient market hypothesis, claims that the price mechanism assures that the long-run choices are optimal and herd behavior is impossible, the driving force behind herd behavior is that in an imperfect or asymmetric information setting and complex information structures, people may rationally take into account the information revealed or signals sent by others’ action.¹³⁶

In addition, herding in financial markets might occur due to the reputation of some of the financial institutions. If a number of investors or fund managers come to the belief that a particular investor or investors have superior ability in stock picking or exploiting any other profitable investment opportunities or believe that they possess private information, they will mimic their investment behavior irrespective of their own opinion and their own proprietary trading models.

Furthermore, there might be circumstances in which most of the investment strategies simultaneously and accidently follow the same direction. This kind of herding arises from the coordination failure in financial markets. For example, in case a financial institution is in distress, their hedge fund counterparties might run on them to seize the collateral they have provided to the financial institution in distress. Although it is in the best interest of all financial institutions not to run on the distressed financial institution, a situation akin to a prisoners’

dilemma emerges in which the individually rational strategy will mean a social disaster with banks going bankrupt and hedge funds losing the value of their collateral. Likewise, runs might occur in financial crises and the firms might flight to quality by unwinding their long term positions and creating a liquidity crunch.

Since hedge funds are less burdened by the regulatory restrictions and requirements, and given they have a broad spectrum of strategies at their disposal, the likelihood of hedge fund herding

135 Avery and Zemsky, Multidimensional Uncertainty and Herd Behavior in Financial Markets, 724-748.

136 Ibid. Behavioral approaches to financial market regulation confirm the possibility of herding in financial markets.

Shiller identifies two sources of volatility of mass behavior; informational cascade, and the nature of information transmission and informational cascade facilitators. For more details see Robert J. Shiller, "Conversation, Information, and Herd Behavior," Ibid. 85, no. 2 (1995), 181-185.

seems very remote. Moreover, a prerequisite for herding is that the financial institutions know about the positions of the other market players, while the opaqueness in hedge funds’ trades renders herding more unlikely. In addition, what makes herding by hedge funds unlikely is that in order to herd, hedge funds should ignore their own private and proprietary information and the analyses produced by their sophisticated analysts, and instead join the herd.

Nonetheless, since most hedge funds disclose some information with regard to their financial positions to their investors and prime brokers, there is always the possibility of leakage of important private and proprietary information. In addition, the anecdotal evidence suggests that prime brokers sometimes inform some of their hedge fund clients about the selective trades by other hedge funds which are clients of the same prime brokers.¹³⁷

Contrary to the theory, systemic concerns about hedge fund herding are amplified by the empirical evidence on herding among hedge fund managers.¹³⁸ Indeed, it is likely that hedge funds with similar strategies take similar positions in financial markets. In the presence of herding among hedge funds, not only should the individual hedge fund’s potential systemic risk be taken into account, but also the leverage of the entire industry should be taken account of. As it is shown in this chapter, the leverage of the individual hedge funds is relatively low and is unlikely to be of systemic implications. However, in the presence of herding and potential simultaneous deleveraging by hedge funds, their overall collective impact on markets can potentially be systemic.

One of the contributing factors for hedge fund risk taking is the incentive fees charged by hedge fund managers. It is shown that under certain circumstances, incentive fees can encourage managers to herd.¹³⁹ By joining the crowd, a manager can free ride on the efforts of other managers.¹⁴⁰ In addition, hedge fund managers have an interest in copying the strategies of their peers. They might also have more incentive to herd in the financial market downturn. This incentive can be highlighted if the managers’ incentives are taken into account in terms of

137 Daníelsson, Taylor and Zigrand, Highwaymen or Heroes: Should Hedge Funds be Regulated? A Survey, pp.

531-532.

138 Boyson, Implicit Incentives and Reputational Herding by Hedge Fund Managers, 283-299.

139 Stephen J. Brown and William N. Goetzmann, "Hedge Funds with Style," Journal of Portfolio Management 29, no. 2 (2003), 101-112.

140 William Fung and David A. Hsieh, "Hedge Fund Replication Strategies: Implications for Investors and Regulators," in Financial Stability Review; Special Issue, Hedge Funds, ed. Banque de France, 2007), pp. 61-62.

protecting their own job as the manager of a hedge fund. In that sense, there is a considerable safety in mimicking the investment strategies of their peers or competitors, because if everybody loses money, they will not be fired. Thus, their poor performance might be excused if they herd.

Given the above pattern of behavior, it is also argued that taking tail risks and herding can reinforce each other.¹⁴¹

Herding behavior in turn might amplify hedge fund contagion which causes the risks to spill over to other sectors of financial system and possibly to the real economy. Herding behavior can give rise to contagion and it can cause substantial co-movements in the prices of securities previously perceived as uncorrelated. Moreover, herding is related to “crowded trades”, a situation in which many market participants hold similar correlated positions. The main concern arises when a herd behavior (similar correlated reactions) is triggered by a shock. This shock may cause abrupt collective exits by hedge funds from crowded trades. In this respect, some commentators highlight the increased correlation between hedge funds’ returns which is an indication of potential crowded trades.¹⁴²

The impact of hedge fund herding on financial stability heavily depends on the depth and scope of the markets in which hedge funds are trading. If they pose material risks to the financial markets by herding, regulatory response is warranted. However, since herding and crowded trades is not a specific feature of hedge funds, its monitoring and regulation requires not only collecting information on the exposure of hedge funds, but also about other institutions such as banks, mutual funds, and other mainstream financial institutions.

141 Raghuram G. Rajan, "Financial Conditions, Alternative Asset Management and Political Risks: Trying to make Sense of our Times," Banque De France, Financial Stability Review; Special Issue, Hedge Funds (April 2007), pp.

140-141.

In addition, Chevalier and Ellison’s empirical work on mutual funds supports the idea that younger managers are punished for deviating from the median industry sector. See J. Chevalier and G. Ellison, "Career Concerns of Mutual Fund Managers," Quarterly Journal of Economics 114, no. 2 (1999), 389-432.

In other words, they find evidence of herd behavior in younger mutual fund managers. Their result confirms the theory proposed by Scharfstein and Stein (1990) indicating that the managers who take the same action as their peers are perceived to have a superior ability. Such a perception can reinforce herd behavior among investors. See David S. Scharfstein and Jeremy C. Stein, "Herd Behavior and Investment," American Economic Review 80, no. 3 (1990), 465-489.

142 Danièle Nouy, "Indirect Supervision of Hedge Funds," in Financial Stability Review; Special Issue, Hedge Funds, ed. Banque de France, 2007), pp. 96-98.