Friday, January 14, 2011

Herd Behavior in the Hedge Fund Industry?

The Wall Street Journal has a thought-provoking article today about herd behavior in the investment choices made by hedge funds. Are these firms actually mimicking each other a great deal? It seems odd, given that the typical notion we have of successful hedge fund managers is that of the independent-minded genius willing to make moves that run counter to the conventional wisdom. After all, by betting against the majority, an opportunity arises to make out-sized gains.

Many explanations can be put forward for the increase in herd behavior, and the article articulates some of those quite well. One notion focuses on the sharing of information that regularly takes place among hedge fund managers. For instance, some of these investors get together for "idea dinners" in which they share philosophies and judgments about particular firms. On the one hand, such sharing of information seems natural given that many of these investors have social ties - they went to the same schools, came from the same larger banking and asset management firms, etc. On the other hand, why do they share so freely? Are they giving away competitive advantage when they share their investment conclusions with others?

My sense is that herd behavior does not derive from the sharing of major secrets at idea dinners per se. Why would investors give away competitive advantage in this way? However, as more and more young MBAs flood the field, we may be seeing people with very similar analytical toolkits, educational backgrounds, prior work experiences, and the like. These folks may have training, but not deep expertise and the pattern recognition ability that comes with lengthy experience in a field. As a result, they may be applying the same models and the same way of thinking. That may be different from the early days of the industry, when you had a few very experienced investors using unconventional and idiosyncratic methods to determine their investment strategies.

1 comment:

ken long said...

what others may view as convergant thinking from the outside,. maybe seen as divergent thinking for the in-group. the young quants may be under the same pressure to perform slightly better than their benchmarks just like mutual fundmanagers. the socialization of risk in their own hedging may account for the phenomemon. It takes experience to be divergent and then stick to it thru the bad times. But that's what fund of fund managers are looking for in a hedge fund, the ability to provide the exposure to ideas who's ideas will be outstanding under certain conditions.

the pure quants should not be affected by the socializing and group think, unless their "quant" edge is to respond to the most recent patetrns in which the algorythms act to tune each other into convergence.