The Price Impact of Institutional Herding

Abstract

In this paper we develop a simple theoretical model to analyze the impact of institutional herding on asset prices. A growing empirical literature has come to the intriguing conclusion that institutional herding positively predicts short-term returns but negatively predicts long-term returns. We offer a theoretical resolution to this dichotomy. In our model, career-concerned money managers interact with profit-motivated proprietary traders and security dealers endowed with market power. The reputational concerns of fund managers imply an endogenous tendency to imitate past trades, which impacts the prices of the assets they trade. We show that institutional herding positively predicts short-term returns but negatively predicts long-term returns. In addition, our paper generates several new testable predictions linking institutional herding behavior, trading volume, and the time-series properties of stock returns.

Keywords: herding, career concerns, institutional investors