Close Connections: Hedge Funds, Brokers and the Emergence of a Consensus Trade

Abstract

We investigate whether social connections within the hedge fund industry affect investment decisions. Data is collected from interviews and observations with 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 an increased probability of consensus trades. We present a detailed case study that shows that such trades introduce an additional risk factor: the underweighting of information from sources outside the trusted connections.