Hedge Fund’s Pack Behaviors

January 22, 2011

The Wall Street Journal (WSJ) recently published a headline article titled “Hedge Funds’ Pack Behaviors Magnifies Market Swings”. While it is not unusual to see the WSJ write on hedge funds and market swings, this article is unusual because it emphasizes the social ties linking investors. It reflects a sea change in the way that the public and the media view financial markets – and an opportunity for the social studies of finance (SSF) to reach a broader audience.

For the past decade, the quant metaphor has dominated public perceptions of financial markets. Institutional investors – particularly hedge funds – were seen as “quants” that used sophisticated computer models to analyze market trends. This idea went hand-in-hand with the view that markets were efficient – fueled by reliable, public data, proceed through sophisticated, rational algorithms, and powered by intelligent computer systems instead of mistake-prone humans.

Of course, the recent financial crisis has dislodged such beliefs. Instead of mathematical geniuses finding hidden patterns in public data, quants were revealed as Wizards of Oz – mere human beings capable of making mistakes. Their tools – computerized systems – went from being the enforcers of an efficient market to a worrying source of market instability. As stories about flash trading and inexplicable volatility popped up, the public even began to ask whether the quants were trying to defraud the public.

If institutional investors are mere humans instead of quantitative demigods, shouldn’t they also act like humans? And – shouldn’t their social natures affect the way they make investment decisions? The mainstream media is finally confronting such questions – which SSF has long raised. This particular WSJ article parallels a widely-circulated working paper by Jan Simon, Yuval Millo and their collaborators, as well as my own work under review at ASR.

The world is finally catching up with SSF. Will we finally be heard? It is our responsibility to reach out to the public and the media.

7 Responses to “Hedge Fund’s Pack Behaviors”

  1. danielbeunza Says:

    JC — excellent post. But I think that since these ideas are already coming to the mainstream, it is now up to sociologists to make clear how their views differ from those of economists. As I see it, the WSJ piece is about the rise of consensus trades, and idea that has its intellectual roots in social networks and institutional theory.

    However, there is a new and interesting twist around the very current notion of “markets and politics.” As it turns out, the push towards imitation is an outcome of the newly arisen centrality of politics in the capital markets, which has made it difficult for market actors to continue relying on their traditional tools. I think that this is a fascinating trend, well worth exploring more.

  2. JC Says:

    Daniel — I absolutely agree that the changed regulatory environment has deprived hedge fund managers of some tools. However, I’d argue that the main reason that hedge fund managers are herding more is that the markets have become far more uncertain than they have been. The old adage that people fall back on their networks in uncertain conditions appear to be borne out here. Perhaps the right way to think about this is that the choice of tools is contingent upon external conditions, including politics but also uncertainty.

  3. Will Davies Says:

    The WSJ article is interesting, because it is undoubtedly more sociological than many accounts of herd behaviour, which tend to be primarily psychological. Very often, ‘the social’ tends to be smuggled into market analyses via behavioural economics, thereby reducing influence to a ‘mental’ or epi-phenomenal issue – rather as the headline to the WSJ article suggests. It is, of course, far more political and cultural than that, but it’ll be interesting to see how much the social studies of finance becomes collapsed into behavioural finance, should it acquire mainstream recognition.

  4. danielbeunza Says:

    Will — agreed! One potential avenue, building on JC’s comment, would be to actually question the idea that greater uncertainty leads to greater imitation.

    I have always been wary of the statement “markets dislike uncertainty.” At the end of the day –as Zuckerman’s (2004) beautifully shows– market actors trade on differences of opinion, and uncertainty is what creates that. The statement, in other words, is akin to saying “academics dislike controversy.” Well, actually, they love it.

    In my view, market actors pull out of the market when the uncertainty is such that they are unprepared to deal with it. When the lack models, databases, visualizations… in short, calculative tools. This is why it is so fascinating to observe what is going on now with the sovereign crisis. From my conversation with Mr. Someone (see previous posts), I found out that investors have had to build up tools to estimate the probability that a country like Spain might default. They did not have them two years ago… the assumption was simply that it would not default.

    So, in other words, an analytical approach that recognizes the many different responses to uncertainty (some imitative, some calculative) would be a great start to address Will’s point.

  5. JC Says:

    @Will: I just had a conversation with two financial economists that supports your thoughts. They were VERY interested and positively engaged in my work on social network effects on hedge fund performance — but suggested that this had been done already by economists. They were actually looking at work that has interesting implications but remains rather primitive by social network standards. Thus, I feel that economists will take twenty years to unknowingly replicate work already done in sociology. Perhaps SSF needs to publish more in the Journal of Finance?

    @Daniel: I agree completely with your thoughts on uncertainty. Come to think about it, Hardie and Mackenzie (2006) combine my point on people falling back upon networks, as well as using specific tools — what they call distributed cognition.

    Perhaps what we need is a more fine-grained view on the responses to uncertainty.

  6. jovan Says:

    As you suggest, my limited connections at funds suggest there is a group think my managers of various funds. The idea of qaunts was amazing…until there were quants everywhere. There will be a new evolution and new praise given once the next method is revealed, copied and proven imperfect.


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