Through sharing research and ideas fund managers can increase both the number and quality of their trading strategies. Empirical evidence suggests that managers share ideas particularly with peers that have both the ability and the intention to provide useful feedback. This implies that portfolio managers’ communication and good intentions are critical for their success in a network of idea generation.

Ganglmair, Bernhard, Alex Holcomb and Noah Myung (2016), “Cutthroats or comrades: Information sharing among competing fund managers”, MPRA Paper No. 71506, 6 May 2016

This post ties in with the importance of exchanging market risk information, in particular at times of heightened systemic risk (view bottom of systemic risk management summary page).

The below are excerpts from the paper. Headings and cursive text have been added.

Basic motivation for sharing trade ideas

“Recent empirical evidence, documenting the extent to which financial trades are correlated, suggests that information sharing among investors continues unabated, and that even hedge fund managers in direct competition with one another appear to share investment ideas…There appears to be evidence…that managers circumvent their own safeguards in order to collaborate with rivals.”

“[Previous academic research] demonstrates that a mutual gain from collaboration (e.g. from sharing ideas) is sufficient to justify communication among fund managers…Competing managers are willing to share ideas for investment opportunities with rivals when they expect to receive feedback in the form of additional ideas or a refinement of the original idea.”

“Players exchange ideas for investment opportunities and…more ideas increase value. The incentive to share an idea depends on the probability of receiving an idea in return. Our theoretical model separates one’s ability to share an idea (which is by a commonly known, that is, objective probability) from one’s intention to share (which requires a rival to form subjective expectations).”

Findings from experimental research

“We find that a manager’s willingness to share an idea increases in her expectations of receiving feedback. We argue that the manager’s expectation of receiving feedback from a rival crucially depends on two aspects. First, a rival manager must have the ability to provide feedback by sharing an idea; this is objective…Second, a rival manager must have the intention of providing feedback. This portion of a manager’s expectation is subjective, and we show that subjects form complex beliefs about their rival’s intention to continue collaboration. Thus, a fund manager expects to receive feedback from a rival manager if both the rival’s ability and intention to provide feedback are sufficiently strong.”

“We further provide evidence that, for a fund manager’s decision to share, subjective expectations about rivals’ intentions matter more than objective expectations about their ability.”

“These results hold even when we control for personal connections, the prevalence of social norms (i.e., fairness and trustworthiness), or risk aversion. Within our study, none of these factors have a consistent effect on a fund manager’s decision to share information. This implies that even rival managers who are not comrades are willing to exchange information driven only by their expectations of receiving feedback.”

The setup of the experimental research

“Our experimental implementation employs a hedge fund management framework in which players exchange ideas for investment opportunities. Communication is a process of back-and-forth sharing of ideas between two hedge fund managers. In each round, a fund manager has the chance to generate a new idea to share. The probability of doing so reflects a manager’s ability. If a manager generates a new idea, she must decide to share the idea with her rival fund manager or conceal it. If she conceals the idea so that no new information is exchanged, the communication ends. If, instead, she shares the idea, then her rival is given the chance to generate a new idea according to her ability. If the rival generates a new idea, she can either share this idea (and thus provide “feedback”) or conceal the idea. If any of the fund managers fail to generate a new idea, then no new information can be shared and the communication ends. The game thus continues an indeterminate number of rounds and ends if either a manager decides to conceal an idea or a manager fails to generate a new idea.”

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“Managers compete across potential investors for their fund, and each manager exerts monopolistic control over a fraction of the market and competes with other managers over the remaining portion. A manager’s compensation increases in the absolute number of investment ideas that she possesses at the end of the game. This part of a manager’s payoffs accrues from the monopolistic segment of the market. This is akin to the portion of a fund manager’s compensation that stems from good performance with the investor capital already under her control. In addition, if a manager holds more ideas than her rival, she captures the competitive segment of the market as well. Thus, the fund manager with the best relative investment performance captures all the remaining uncommitted investor capital.”

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“This combination of the absolute and relative number of ideas introduces a straightforward trade-off: on the one hand, it incentivizes managers to share ideas so as to increase the number of ideas and thus increase payoffs from the monopolistic side of the market; on the other hand, it gives each manager an incentive to conceal ideas in order to capture the competitive side of the market.”

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Ralph Sueppel is founder and director of SRSV Ltd, a research company dedicated to socially responsible macro trading strategies. He has worked in economics and finance for almost 25 years for investment banks, the European Central Bank and leading hedge funds. At present he is head of research and quantitative strategies at Macrosynergy Partners.