Hedge Fund Social Networks
Do Hedge Funds Rely Too Much on Social Networks?
Is a growing reliance upon social networks by many hedge fund professionals causing them to ignore risks and make imprudent trading decisions? That's the main thrust of recent research by several academics in a recent study, "Close Connections: Hedge funds, brokers and the emergence of a consensus trade." The researchers looked at how hedge fund professionals relied on their contacts at rival hedge funds (many of these contacts are individuals the trader previously worked with) to help form their decisions, sometimes with poor results. The problem occurs when hedge funds are "underweighting of information from sources outside the trusted connections."
Quantitatively analysing the mapped social network, the authors found that decision-making relies on an elaborate two-tiered structure of connections among managers and between them and brokers. "This structure is underpinned by idea-sharing between competing hedge funds, leading to an increased probability of consensus trades," says the research. "Such trades introduce an additional risk factor: the underweighting of information from sources outside the trusted connections."
According to Yuval Millo, one of the authors of the paper and a lecturer in accounting at LSE specialising in the sociology of financial markets, the networks are not necessarily negative but 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. We found that this is not just a fringe phenomenon. There is enough of it going on to make the market vulnerable," he says.
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 hedge funds focus on an investment idea and ignore warning signs they might reasonably be expected to notice.
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