DOES REPUTATION CONTRIBUTE TO INSTITUTIONAL HERDING?

AuthorZhaojin Xu,Marius Popescu
Date01 September 2014
DOIhttp://doi.org/10.1111/jfir.12038
Published date01 September 2014
DOES REPUTATION CONTRIBUTE TO INSTITUTIONAL HERDING?
Marius Popescu
University of Massachusetts Boston
Zhaojin Xu
University of Massachusetts Dartmouth
Abstract
We examine the reputational herding hypothesis and provide evidence that institutional
investorscareer concerns contribute to herding behavior. Our analysis is based on the
intuition that stronger (weaker) career concerns lead to a higher (lower) propensity to
herd in down (up) markets. We nd that institutional herding is, on average, 40% greater
in down markets than in up markets. Moreover, we nd that mutual funds and
independent advisors follow same typeinstitutions 43% more in down markets than in
to up markets. Our evidence suggests that institutional herding is driven, at least in part,
by institutional managersreputational concerns.
JEL Classification: G11, G14, G23
I. Introduction
Consistent with public perceptions, recent empirical work documents strong evidence that
institutional investors herd (e.g., Sias 2004; Choi and Sias 2009; Dasgupta, Prat, and
Verardo 2011a; Puckett and Yan 2010). Pre vious work identies ve reasons for this
phenomenon: reputational herding, underlying investorsows, momentum and/or other
styletrading strategies, investigative herding, and informational cascades. According to
the reputational herding hypothesis, institutional investors imitate each otherstradesto
preservetheir reputations. Institutionsmay also herd as a result ofthe timeseries correlation
in underlyinginvestorsows (e.g., Frazziniand Lamont 2008) or if they have a preference
for stocks with certain characteristics as in Barberis and Shleifers (2003) style investing
model. At the sametime, according to the investigative herding models,institutions follow
each other into and out of the same securities either because they act on the same
information (e.g., Froot, Scharfstei n, and Stein 1992), or because some institutions acquire
the informationbefore others (e.g., Hirshleifer, Subrahmanyam, and Titman 1994).Finally,
according to the informational cascades hypothesis, institutional investors herd because
they infer information from each others trades and thus nd it optimal to follow the herd
instead oftrading on their own information(e.g., Banerjee 1992;Bikhchandani, Hirshleifer,
and Welch 1992).Previous empirical work (e.g., Nofsinger and Sias 1999;Wermers 1999;
Sias 2004; Choi and Sias 2009; Brown, Wei, and Wermers 2014) largely supports the
We would like to thank an anonymous referee, Steve Jones, the associate editor, and Rick Sias for the many
helpful comments and suggestions.
The Journal of Financial Research Vol. XXXVII, No. 3 Pages 295321 Fall 2014
295
© 2014 The Southern Finance Association and the Southwestern Finance Association
RAWLS COLLEGE OF BUSINESS, TEXAS TECH UNIVERSITY
PUBLISHED FOR THE SOUTHERN AND SOUTHWESTERN
FINANCE ASSOCIATIONS BY WILEY-BLACKWELL PUBLISHING
investigativeherding, style investing, and informationalcascades explanations.As noted by
previous authors, however, these explanations are not mutually exclusive.
In this study, we present evidence that reputational herding may also contribute to
institutional herding. Previous studies provide a strong theoretical foundation for the link
between managersbehavior and their career/reputational concerns. Specically, these
studies argue that institutional investors may herd because they face a reputational cost
from acting different from the herd. In other words, it is more costly to be alone and wrong
than to be with the herd and wrong (e.g., Scharfstein and Stein 1990; Dasgupta, Prat, and
Verardo 2011b).
1
Our rst test of the reputational herding hypothesis is based on the intuition that
professional managers will have a stronger incentive to herd in down markets relative to
up markets. Following down markets, the aggregate inows into institutions are lower
(e.g., Warther 1995; Karceski 2002), thus leading to an increase in closures (e.g.,
Zhao 2005b), a decrease in new institution openings (e.g., Zhao 2005a), and an increase in
the probability of job loss for professional fund managers (e.g., Chevalier and
Ellison 1999). Kempf, Ruenzi, and Thiele (2009) examine the risktaking behavior of
equity fund managers across different market states, and they nd that fund managers
decisions are inuenced by their desire to keep their jobs (employment incentives) during
bear markets and to earn higher compensation (compensation incentives) during bull
markets. Although an argument can be made that managers may face a reputational cost of
deviating from the herd in both market states, we argue that this cost is much higher in
down markets than in up markets. Specically, during up markets, the cost of deviating
from the herd (in case the herd made the right decision while the investor did not) may be a
decrease in compensation in most cases, and job loss in some cases (e.g., Chevalier and
Ellison 1999). However, during down markets, deviating from the herd may lead to job
loss in most cases (e.g., Chevalier and Ellison 1999), but it could also lead to the complete
destruction of the managers reputation, and even to the possibility of never nding
another job in the industry (e.g., Kempf, Ruenzi, and Thiele 2009). Based on this
argument, we expect the incentive to herd to be stronger in down markets than in up
markets, thus leading to stronger herding behavior in down markets than in up markets.
Our second test of the reputational herding hypothesis is based on the intuition
that some institutional investors have greater reputational concerns than others. Previous
work (e.g., Del Guercio 1996; Bennett, Sias, and Starks 2003) suggests that different
types of institutional investors face different environments (e.g., regulatory requirements,
holding periods, competition, etc.) that inuence their trading behavior. Moreover, Sias
(2004), Choi and Sias (2009), and Dasgupta, Prat, and Verardo (2011a) hypothesize that
mutual funds and independent advisors are most likely to experience changes in investor
ows as a result of changes in their reputation. Furthermore, Sias (2004) posits that if
career concerns contribute to herding behavior, institutional investors are more likely to
1
In support of this argument, John Meynard Keynes argues in The General Theory of Employment, Interest
and Money (1936) that it is better to fail conventionally than to succeed unconventionally (pp. 15758).Moreover,
Jean Claude Trichet, president of the European Central Bank, is credited with the following comment: Some
operators have come to the conclusion that it is better to be wrong along with everybody else, rather than take the risk
of being right, or wrong, alone(Fifth European Financial Markets Convention, Paris, June 15, 2001).
296 The Journal of Financial Research

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