Close communications: hedge funds, brokers and the emergence of a consensus trade

Jan Simon, Yuval Millo, Neil Kellard and Ofer Engel

Abstract

ABSTRACT

In this paper, we examine how communication practices among competing market actors lead to overembeddedness, and whether such practices impact on market-wide phenomena such as prices and risk. Data is collected from interviews and observations, with hedge fund industry participants in Europe, the United States and Asia. Quantitatively analyzing the mapped social network, we find that decision making relies on an elaborate two-tiered structure of connections among hedge fund managers, and between them and brokers. This structure is underpinned by idea sharing between competing hedge funds leading to overembeddedness and an increased probability of popular consensus trades. We present a detailed case study that illustrates the role that communication between competing hedge funds plays in the creation of consensus trades, and shows that such trades affect prices by introducing an additional risk: the disregarding of information from sources outside the trusted connections.