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Hedge funds not big herders, says academic study

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GLOBAL - A new academic study of the holdings of hedge funds that file so-called '13f reports' with the US Securities and Exchange Commission has found that they herd into the same positions less than other investment institutions, have less portfolio overlap and are less likely to engage in momentum trading.

Contrary to popular perception and some previous academic studies, 'Hedge Fund Herding and Crowded Trades: The Apologists' Evidence', published by the Social Science Research Network (SSRN), found that, on average, "hedge fund demand appears to push prices towards equilibrium, whereas non-hedge fund institutions' demand pushes prices away from equilibrium".

The paper's authors - Blerina Reca of the department of finance in the University of Toledo's College of Business Administration, Richard Sias of the department of finance in the University of Arizona's Eller College of Management, and Harry Turtle of the department of finance in West Virginia University College of Business and Economics - make it clear they do not claim hedge funds never herd or destabilise asset prices.

The point of the study is that it does find herding and crowding, "just to a much lesser extent, on average, than other institutional investors".

In this respect, the new study does not necessarily contradict previous studies that have raised the possibility that sophisticated investors can move market pricing away from fundamentals, such as those by Jeremy Stein or Dilip Abreu and Markus Brunnermeier, or even those that have uncovered empirical evidence of hedge-fund herding, such as Itzhak Ben-David, Francesco Franzoni and Rabih Moussawi's recent study of trading during the quant meltdown and financial crisis of 2007-08, or the work on clustering and correlation associated with Andrew Lo.

However, the paper does find that hedge funds' "herding propensity", defined according to a metric developed by the authors, is eight-times less than that of non-hedge fund institutions.

Moreover, while non-hedge fund institutional herding is positively related to market stress, the same is not true of hedge funds' herding.

Testing to find whether or not hedge funds "herd to the same ideas" - resulting in crowded trades - the authors compare the portfolio overlap for every pair of hedge funds with the portfolio overlap for every pair of non-hedge fund institutions.

They find that the average non-hedge fund pair exhibits four-times the overlap of the average hedge fund pair.

Considering the extent to which hedge funds drive prices away from fundamentals, the authors compare aggregate demand for stocks with subsequent returns over the period 1998-2010.

They find that non-hedge fund aggregate demand exhibits an inverse relationship with subsequent returns over the proceeding year, but a positive relationship when it comes to hedge funds.

The authors claim to have put together the first direct broad comparison of hedge funds versus non-hedge funds' potentially destabilising herding and crowded trades using quarterly 13(f) filings, and emphasise their findings' relevance to current regulatory debate.

"Arguably," they write, "appropriate policy responses (such as the European Union's Alternative Investment Fund Managers Directive and the US Dodd-Frank Act) should consider a holistic approach that admits comparisons between hedge funds and other institutions when attempting to measure the social costs and benefits of potential regulatory changes."

Christen Thomson, director of external affairs at hedge fund industry body the Alternative Investment Management Association, told IPE: "AIMA, which recently cooperated with KPMG and Imperial College in London on research about the value of the global hedge fund industry to investors, markets and the broader economy, naturally welcomes the findings of [this new] research."

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