Journal Of Network Theory In Finance

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

Jan Simon, Yuval Millo, Neil Kellard and Ofer Engel

  • We examine how communication practices among competing hedge funds are related to excessive reliance on information and interpretations from trusted sources (i.e. over-embeddedness of social ties). We find that such practices have market wide impacts phenomena such as prices and risk. 
  • Decision making is underpinned by idea sharing between competing hedge funds that may lead to over-embeddedness and an increased probability of popular consensus trades. 
  • A detailed case study that illustrates the creation of a consensus trade (the Porsche-VW short squeeze of October 2008) and shows the risks of over-embeddedness in financial markets is presented.

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.

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