Hedge Funds and Herding Behaviour

This chapter examines whether hedge funds herd, how this herding occurs, and any potential market wide effects. Bringing together the mainstream finance literature and that from a more management and sociological perspective, it is shown that hedge funds herd, although there is some evidence this is less than other large institutional investors. Mechanistically, such consensus trades occur because hedge firms communicate within tight knit clusters of trusted and smart managers, who share and analyze trading positions together. This industry structure is a function of the hyper decision-making environment faced by hedge fund managers, coupled with a desire for legitimization and to maintain reputation. Finally, note that hedge fund herding can have market wide effects either directly via network risk and indirectly, as follower institutional investors amplify hedge fund trading patterns.