Strong evidence exists that mutual funds herd into or out of stocks in an effort to mimic hedge funds. Mutual fund herding is associated with a significant impact on prices that can be destabilizing and lead to sharp price reversals.
What’s Inside?
Hedge funds’ investment strategies have attracted significant media attention in recent years and are believed to be having an impact on mutual funds. The authors explore and measure the impact of herding and the reasons for expecting mutual funds to herd after hedge funds herd. They find that hedge fund herding contains future return–related information, contributes to information discovery, and speeds the stock price adjustment process, which causes subsequent mutual fund herding to lead to sharp price reversals.
How Is This Research Useful to Practitioners?
The authors are the first to examine whether and to what extent mutual funds follow and herd after hedge funds herd. This research and related studies are topical because they address the trend among mutual fund families to launch funds specifically designed to mimic hedge funds. The authors contribute to the existing literature that explores institutional herding behavior in general and the performance of “hedged” mutual funds and managers of side-by-side hedge and mutual funds in particular.
Understanding the impact on price of mutual funds’ response to hedge fund herding adds to the literature on stock price predictability and how the exploitation of predictable trades can be a potential source of alpha for managers who apply this knowledge.
How Did the Authors Conduct This Research?
The authors explore mutual fund trading in the same direction sequentially in the current quarter when hedge funds have herded in the previous quarter. They explore both buy-side herding and sell-side herding (i.e., capture the trading direction) as well as control for mutual funds’ preference for certain stock characteristics and investment styles. Previous research found that there is no relationship between an average mutual fund’s tendency to herd and its performance. The authors’ herding measure is calculated at the firm level for hedge funds and at the fund level for mutual funds. They control for a number of factors known to affect institutional herding (e.g., preferences for certain stock characteristics and styles) as well as the potential that the discovered price destabilization effects may be driven by hedge funds themselves or continuous/contemporaneous herding.
The theoretical literature hypothesized that herding may result from four motivations that are driven by incentives unrelated to stock fundamentals: (1) Mutual funds may infer information from prior trades of hedge funds that dominates their own information, (2) mutual funds may choose to investigate the same information as hedge funds, (3) managers may copy hedge funds to look smart, or (4) managers are concerned about reputation damage if they act differently from others. The authors find a positive association between intense herding and a manager’s reputation. Furthermore, when mutual funds and hedge funds herd in response to common information, they do not stabilize stock prices.
Abstractor’s Viewpoint
It is well known that many investors flock together in trading, and such correlated trading might have a tangible impact on prices. The authors confirm that crowd behavior is deliberate. Their findings that mutual funds are more inclined to herd than hedge funds and that hedge fund herding tends to concentrate in a smaller number of stocks are important contributions to practitioners’ understanding of the impact of institutional trading on stock prices. This information combined with a recognition that institutional herding is positively associated with the informational uncertainty about a stock—particularly those with extreme previous returns—is valuable to all equity managers interested in understanding the impact of fund flows.