Humans are hard-wired to herd. In risky situations, our primal instinct is to seek safety in numbers. Straying from the pack exposes us to the dangers of isolation: predators, injury, disorientation. For professional investors, the chief benefit of herding is the mitigation of career risk. There is no other upside. Herding generates momentum, which fuels asset bubbles that can last for years. Each time, some investors will be convinced markets have reached a new plateau. Others will buy-in because profits – no matter how unjustified – are irresistible. Yet bubbles burst inevitably, and these exercises in herding end in tears for most.
Away from the pack, however, the few investors who manage to short-sell bubbles or stick to their valuations – and remain solvent – feel vindicated, relieved, and much wealthier after taking such immense career risks. The eventual payoff – whether it is attributable to true grit or alpha – is huge. So herding doesn’t shield investors from investment risk, but it is a sure way for investors to avoid underperforming in isolation. It also kills investment opportunities. For example: the hedge fund industry, in aggregate, is now comprised of net long exposures now that it has amassed $1 trillion from investors looking for the same thing – uncorrelated returns – in the same place.
Most pension funds and their members haven’t benefited from this, and while some hedge fund managers with no special talent may have scored some easy fees, their reputation as uncorrelated alpha generators and future business prospects are tarnished. So no one has really won. Roger Urwin, Towers Watson’s global head of investment content, put this before super fund chiefs and sponsoring managers at the FEAL conference this year. “You have the world’s most cultured and intelligent pension system – credit where it’s due – but you have pretty much the world’s worst case of peer group obsession,” he said. “Your investment industry lacks leadership. Who speaks for the averages exactly? In this you are serving neither your own interests nor your members.” For investors, herding is at once a survival instinct and a weakness. But for those who are sure in their convictions and have the guts and stakeholder support to implement them, it’s an inefficiency that can be exploited.