Hedge fund mangers tend to use connections with competing fund managers to compare and test initial trading ideas. This can introduce a risk factor: underweighting information from outside sources.

Hedge fund managers may depend too much on their network of contacts when making investment decisions, concludes research*.

This is the first time detailed analysis has been done on the social structures and practices through which investment decisions are made in hedge funds.

Hedge fund managers tend to use small, cohesive networks made up of competing fund managers to compare and test initial trading ideas and to look for potential flaws in their planned investment strategies, concludes the research conducted by the London School of Economics (LSE), IESE Business School and the University of Essex.

Quantitatively analysing the mapped social network, the authors found that decision-making relies on an elaborate two-tiered structure of connections among 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," says the research. "Such trades introduce an additional risk factor: the underweighting of information from sources outside the trusted connections."

According to Yuval Millo, one of the authors of the paper and a lecturer in accounting at LSE specialising in the sociology of financial markets, the networks are not necessarily negative but are an "amplifying mechanism".

"They increase the likelihood that a group of hedge funds can all head off in a wrong direction with an investment idea. We found that this is not just a fringe phenomenon. There is enough of it going on to make the market vulnerable," he says.

The networks are bound together by trust and reciprocity. All the hedge fund managers the researchers looked at had worked in a previous job with at least one other person from the group, often on the same trading desk.

However, reliance on their own networks can mean hedge funds focus on an investment idea and ignore warning signs they might reasonably be expected to notice.

In an interview with Hedge Funds Review, Millo says managers who tend to hold positions longer are more at risk of using a social network as the basis for their decision to buy and hold. He recommends managers introduce some "noise" into their decisions although he concedes social networks are "very useful" for managers.

Data and interviews were conducted between December 2007 and June 2009 with the researchers interviewing 60 hedge fund managers, brokers, analysts and traders from 26 hedge funds and eight brokerage companies in Europe, the US and Asia. The majority of research was done with London-based managers and brokers.

The sample used represented 15% of total assets under management by hedge funds at the time. Managers interviewed ran long/short and event driven strategies and had AUM of $5 billion or more.

*Close Connections: Hedge funds, brokers and the emergence of a consensus trade by Jan Simon of IESE Business School, Yuval Millo of the London School of Economics (accounting department), Neil Kellard of the University of Essex, Essex Business School, and Ofer Engel of the London School of Economics (department of management).