Mutual Fund Herding and the Impact on Stock Prices (Digest Summary)

Several theories suggest that institutional investors might trade together, or in
“herds.” These theories claim that institutional investors herd because they
have an aversion to acting differently from other managers, receive correlated private
information, infer private information from the prior trades of better-informed
managers, and share an aversion to stocks with certain characteristics. Past research
provides some support that institutional investors trade in herds.

The sample includes almost all mutual funds existing at any time during the 20-year
period from 1975 to 1995. Over this period, dramatic increases occurred in the number of
funds (from 393 funds to 2,424 funds), average fund size (from $98.6 million to $401.3
million), and the average number of stocks held per fund (from 44.6 stocks to 89.5
stocks). Wermers measures herding during calendar quarters by examining the proportion
of funds that are buyers of a given stock. Thus, funds exhibit herding behavior if
stocks tend to have large imbalances between the number of buyers and sellers.

The results show that the overall levels of herding by mutual funds in the average stock
are not very large. Herding slightly decreases as trading activity by funds increases.
For example, the average level of herding decreases for stocks traded by at least 5
funds compared with stocks traded by 50 or more funds. Growth-oriented funds show a
greater tendency to herd than income-oriented funds. For example, aggressive growth
funds have a level of herding about twice that of growth and income funds. Specialty
funds, as indicated by Wermers' “International or other” category, show the
greatest tendency to herd.

Wermers also examines levels of herding in subgroups of stocks with certain
characteristics, such as similar market capitalizations and past returns, and with
buy-side or sell-side mutual fund trading. The evidence shows that herds form more often
on the sell-side than on the buy-side in trades of small stocks, but levels of buy-side
and sell-side herding are similar for larger stocks. The most compelling evidence of
herding occurs in sales of small stocks by growth-oriented funds. The levels of herding
are also higher for stocks having extreme prior-quarter returns. Herding on the buy side
is strongest in high-past-return stocks; herding on the sell side is strongest in
low-past-return stocks. The results show little evidence of a relationship between
sell-side herding and window-dressing strategies.

Wermers investigates whether stocks experiencing high levels of herding show a
significant price adjustment and whether any such price adjustment is temporary or
permanent. The results show a relationship between abnormal stock returns and the
direction of herding in stocks. Stocks that are bought in herds outperform stocks that
are sold in herds during the following six months. This return difference is
particularly pronounced for small stocks. Another finding is that past returns are
highest for stocks bought in herds and lowest for stocks sold in herds. Stocks sold in
herds, however, exhibit a larger future return than stocks bought in herds. Future
return differences appear to be permanent. Finally, the results show that herding speeds
up the price-adjustment process and is not destabilizing. Wermers' use of quarterly data
prevents him from making conclusions about whether herding destabilizes daily or weekly
stock prices.