The Price Impact of Institutional Herding

In this paper we develop a simple theoretical model to analyze the impact of institutional herding on asset prices. In our model, career-concerned money managers interact with pro…t-motivated proprietary traders and security dealers endowed with market power. The interaction between these three classes of traders generates rich implications. First, we show that the reputational concerns of fund managers imply an endogenous tendency to imitate past trades, which, in turn, impacts the prices of the assets they trade. Second, our model predicts a negative correlation between institutional herding and long-term returns. We show that, in markets dominated by fund managers, assets persistently bought (sold) by fund managers trade at prices that are too high (low) and thus experience negative (positive) long-term returns, after uncertainty is resolved. Third, our model can generate a positive correlation between institutional herding and shortterm returns. Our theory thus provides a simple and uni…ed framework within which to interpret the empirical literature on the price impact of institutional herding. In addition, our paper generates several new testable predictions linking institutional herding behavior, contractual incentives, trading volume, and prices. We are grateful to Dilip Abreu, Markus Brunnermeier, Doug Diamond, Stephen Morris, Guillermo Ordonez, Hyun Shin, Dimitri Vayanos, Wei Xiong, seminar audiences at IESE-ESADE, Minnesota (Economics Department), Princeton (Bendheim Center), the Seminaire Roy, Tilburg, University of Chicago (Mathematical Finance seminar), the University of Illinois-Chicago (Finance Department), as well as conference participants at the Chicago GSB Conference “Beyond Liquidity: Modelling Financial Frictions”, and the Cambridge Workshop on Information Externalities, Social Learning, and Financial Markets for helpful comments. Correspondence address: London School of Economics, Houghton Street, London WC2A 2AE, UK. E-mail: [email protected]; [email protected]; [email protected].