The IMF Financial Stability Report highlights two systemic weaknesses of plain-vanilla mutual funds: incentives for end investors to rush for the exit in distress and incentives for portfolio managers to herd. With deteriorating market liquidity and greater systemic importance of collateral values, these weaknesses become a greater concern for the global financial system.
Herding arises from deliberate decisions of informed traders to follow others. It can create inefficiency, dislocations and, hence, profit opportunities. A paper by German academics suggests that herding is the more intense the better informed the market is and the greater the information risk. The paper also finds that both sell-herding and buy-herding increased during the last financial crisis.
A theoretical Bank of Japan paper suggests that instability and herding in bond markets arises from low overall confidence of investors, great importance of public information (such as central bank announcements), and high value of privileged information. This analysis goes some way in explaining drastic bond market moves in the age of quantitative easing, such as the 2013 JGB market sell-off.
The rapid growth in local-currency bond markets in emerging countries has transferred foreign exchange risk from local borrowers to global institutional investors and mutual funds. Gross capital inflows have soared, magnifying the dependence of flows on mutual fund holdings, particularly on volatile open-ended fixed income funds. In the wake of these changes the “beta” of local emerging market assets has risen and the tendency towards herding has increased.
Herding is a deliberate decision to imitate the actions of others. In financial markets with private information herding can be efficient for an individual asset manager, but increases the risks that the market as a whole is inefficient and fragile, particularly in the case of “information cascades”. A paper of Michael McAleer and Kim Randalj provides empirical evidence of herding in a range of futures markets.
A new IMF paper suggests that so-called “long-term institutional investors” have largely turned pro-cyclical in recent crises. This feature may be structural and reflect (a) underestimation of liquidity needs in boom times, (b) failure of traditional risk management systems to appreciate tail risk, (c) asset managers’ short-term performance targets, (d) links between short-term performance disclosures and asset outflows, and (e) regulations and conventions that encourage herding.
Herding denotes broad uniformity of buying and selling across investors. If the transactions of one institution encourage or reinforce those of another, escalatory dynamics, liquidity problems, and pricing inefficiencies ensue. A Federal Reserve paper (which I noticed belatedly) provides evidence of herding in the U.S. corporate credit market during the 2003-08 boom-bust experience, particularly during sell-offs. Bond herding seems to be stronger than equity herding. Subsequent to herding dynamics price reversals have been prevalent, consistent with the idea of temporary price distortions.
Macrosynergy is a London based macroeconomic research and technology company whose founders have developed and employed macro quantamental investment strategies in liquid, tradable asset classes, across many markets and for a variety of different factors to generate competitive, uncorrelated investment returns for institutional investors for two decades. Our quantitative-fundamental (quantamental) computing system tracks a broad range of real-time macroeconomic trends in developed and emerging countries, transforming them into macro systematic quantamental investment strategies. In June 2020 Macrosynergy and J.P. Morgan started a collaboration to scale the quantamental system and to popularize tradable economics across financial markets.
