Study sheds light on mechanics behind “herding” in equity markets
| Apr 15th, 2009 | Filed under: Academic Research, Editor's Pick, Today's Post | By: Alpha Male |
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A new academic study examines how equity betas jump with the release of earnings announcements. It seems that, as in the hedge fund industry, a dearth of information in equity markets can lead to an over-reaction when news is finally released – even if that news is about a competitor.
It’s a widely-accepted axiom that “correlations go to one” in times of distress. In volatile periods like August 2007 and October 2008, hedge funds using seemingly disparate, unrelated strategies, tend to exhibit strikingly similar performance. This is often blamed on a “flight to liquidity” that can have a similar effect across different strategies. At its heart, such a run for the exits is usually precipitated by investors who extrapolate specific occurrences (e.g. a fund collapsing) across the entire industry. In fairness, this may be a good bet. After all, what affects one fund is bound to affect other funds operating with similar strategies.
A new study by academics at Oxford University and the London School of Economics shed some light on this phenomenon. Michael Patton and Michela Veradero find that individual stocks also experience an increase in correlation with their peers when they announce any news.
This makes intuitive sense. When a company announces news such as earnings, information-starved investors are likely to jump on that as an indication of industry conditions. As a result, the fortunes of competitors, suppliers and other industry participants respond accordingly.
They divide the beta of individual securities into its two components: relative volatility and covariance. While volatility relative to the market is bound to change when news is announced, they find that the lion’s share (80%) of any change in beta can be attributed to a pop in the covariance.
As the authors put it: More…
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