Keep your friends close — but not too close

by March 14, 2012

Looks innocent, but cost $38 billion

The longstanding myth of rational financial markets continues to be eroded by research into the behaviour of actual investors. In a recent study conducted by academics at IESE, the London School of Economics, and the University of Essex, it is hedge funds – the alpha thinkers of the investing world – that turn out to rely on all-too-human approaches to making decisions.

Many hedge fund managers, its authors demonstrate, develop their investing strategies at least in part by talking through their ideas with a closed network of trusted contacts in other firms – typically former colleagues from previous employers. While the majority of the time this practice is a useful one for the hedge funds, it significantly increases the likelihood of “consensus trades” and all the risks associated with such.

The authors offer the Porsche-VW market shock as a classic example of the problem. In 2008, a number of hedge funds took large “short” positions on Volkswagen stock (shorts are when an investor borrows a given number of shares from one party and sells them to another when the share price is high, judging that the stock will then decline before the investor has to buy it again to return the shares it borrowed – and keeping the difference in the two prices), doing so after discussing the strategy extensively within their closed networks, but ignoring countervailing advice from brokers and analysts. When Porsche suddenly revealed that it had amassed nearly 75% of VW shares, the stock jumped in price – and then rocketed upward to $1,276 (US) a share, making VW briefly the most valuable company in the word, as hedge funds tripped over themselves buying stock to return the shares they had borrowed. Making the situation worse was the fact that the hedge funds had borrowed 13% of VW’s pool of stock, but only 6% of it remained to be actually purchased after the Porsche buy-up. By the time the frenzy was over, hedge funds, banks, and other investors had lost $38 billion on their short positions.

Observes the LSE’s Yuval Millo, “The hedge funds’ social networks did not cause the crisis but they certainly increased its impact. This wasn’t just one or two hedge-funds making the wrong decisions – this was one of the largest losses on a single company’s shares ever taken by hedge funds.”

Hedge Funds Review interviews Dr. Millo on the team’s findings and directions for further research.