Hedge fund managers are often viewed as being in the middle of it all, at the nexus of various global information networks. It’s easy to assume that the more “networked” a hedge fund manager, the more access to information they will have. Clearly, this privileged position gives hedge fund managers access to both market information and information about their rivals.
So we were surprised to read an article recently about a research study suggesting that “the nosier a hedge fund manager is about the affairs of their rivals, the worse his or her investment returns will be.” The article goes on to report that the paper’s authors conclude that “spying on the neighbours is damaging … as it can lead to poor investment performance and increased risk.”
The paper in question was authored by Charles Baden-Fuller and Vanina Torlo of the Cass Business School in London and Simone Ferriani and Stefano Mengoli of the University of Bologna. But our reading of it suggests the media may be taking some creative license in describing it. The evidence presented in the paper is thought-provoking, but in our view falls short of the kind of clear-cut answers for which the main stream media hungers. (In fairness, the paper comes with the disclaimer that it is still a “work in progress.”)
The authors wonder if being highly networked was really good for returns. Of course, there is not recognized metric for the “interconnectedness” of a hedge fund. So they use a hedge fund’s number of prime broker relationships as a proxy. In fact, they contend that “a few [funds] may choose multiple well-connected Prime Brokers such as Goldman Sachs, UBS, Bear Stearns or Morgan Stanley each with several hundred Hedge Funds in their direct network – to maximize this exposure.”
They theorize that hedge funds with multiple prime brokers might be inundated with trading ideas, might be pitched on over-pitched trades or might even gain access to excessive amount of old or unreliable information. The “dark side” of increased networking manifests in lower returns and higher volatility for the most interconnected funds.
Based on data from 2,000 hedge funds reporting to the TASS database in 2006, they found that about 140 (7%) of the funds they studied had multiple prime brokerages. This number is surely much higher now as a result of the Lehman fiasco. After LTCM, industry critics called for fund’s to consolidate their trading with one prime broker so that organization would have a holistic and complete view of the fund’s risk profile and leverage. But after Lehman, critics changed their tune and warned that hedge funds should diversify their business to protect their assets. Now we hear that the use of multiple primes indicates some kind of “spying” and “nosiness.” Go figure.
In any event, the study contains a fascinating chart showing the interconnectedness of the hedge fund industry along the lines of prime brokers. (We’ve edited it a little to make it easier to read – click to enlarge.)
The critical question, of course, is whether prime broker relationships are an adequate proxy for network interconnections. As we suggest above, there are many widely reported reasons for a hedge fund to use multiple prime brokerages: to mitigate risk (especially after 2007), to handle different types of securities or geographies, or simply because a fund’s existing PB wasn’t on a managed account client’s preferred list. (Side note: As head of marketing for a TASS constituent with multiple prime broker relationships in 2006, I can say that our motivation was definitely not to access to more trade ideas.)
The paper aims to build on the “rich research tradition on the role of social networks in economics.” The introduction cites previous research that concludes:
Networks feature prominently in the Hedge Fund industry. Recent ethnographic evidence suggests that a Hedge Fund is seldom an entity that confronts a market ‘on its own’. More typically, it is part of a rich network of interpersonal and inter-organizational connections, through which support is channeled and information circulates, including research reports, news, prices, as well as information about the behavior of other market actors.
Yet, the paper seems to downplay the role of social networks based on informal (non-prime broker) interactions…
The Hedge Fund industry has a sparsely connected structure, since Funds are not formally linked with others, except via the intermediary of the prime brokers.
The proposition that highly networked hedge funds may face a glut of questionable information that could hurt performance seems intuitively reasonable. And the finding that “multi-primed” hedge funds have inferior performance is thought-provoking. But after reading the paper, we couldn’t help but wonder if there might be another, more direct reason why hedge funds with multiple prime brokers in 2006 seemed to perform worse.