The People in Your Neighborhood: Social Interactions and Mutual Fund Portfolios

Veronika Krepely Pool

Indiana University – Kelley School of Business – Department of Finance

Noah Stoffman

Indiana University – Kelley School of Business – Department of Finance

Scott E. Yonker

Indiana University – Kelley School of Business – Department of Finance; Cornell University

Journal of Finance, Forthcoming

Abstract:

We find that socially connected fund managers have more similar holdings and trades. The portfolio overlap of funds whose managers reside in the same neighborhood is considerably higher than that of funds whose managers live in the same city but in different neighborhoods. These effects are larger when managers are neighbors longer or are of a similar ethnic background, and are not explained by preferences. Valuable information is transmitted through these peer networks: a long-short strategy composed of stocks purchased minus sold by neighboring managers delivers positive risk-adjusted returns. Unlike prior empirical work, our tests disentangle the effects of social interactions from community effects.

The People in Your Neighborhood: Social Interactions and Mutual Fund Portfolios – Introduction

Despite the important role professional money managers play in financial markets, and decades of academic study, relatively little is known about how they generate investment ideas. Research has found that managers invest in companies headquartered nearby (Coval and Moskowitz, 1999, 2001), and in companies to which they are linked through school networks (Cohen, Frazzini, and Malloy, 2009). They also choose stocks based on their political ideology (Hong and Kostovetsky, 2012) and stocks with which they are merely familiar (Pool, Stoffman, and Yonker, 2012). But humans are, as Aristotle famously noted, social animals, so perhaps fund managers also trade stocks that they learn about from other managers. While numerous papers examine the effects of social interaction on choices in other domains,1 there is little empirical evidence on how word-of-mouth communications in uence professional investors’ decision to trade a stock. Hong,

Kubik, and Stein (2005) take an important first step in answering this question by studying a broad sample of mutual funds. They show that the holdings and trades of fund managers who work in the same city are correlated.2

Although these results are consistent with the hypothesis that professional money managers transmit investment ideas socially,3 the authors point out several alternative hypotheses that are difficult to rule out with their data. Specifically, the correlation in portfolios could be due to fund managers in the same city being exposed to the same local media outlets, being visited by the same corporate executives during investor-relations road shows, or by herding with local managers, which could be induced by geographic segmentation of the job market combined with career concerns (Scharfstein and Stein, 1990; Chevalier and Ellison, 1999). These alternative \community effects” would imply that news travels through formal information channels, whereas the social hypothesis implies that information travels through informal person-to-person relationships. Of course, bothchannels can operate simultaneously, and in this paper we implement a test that allows us to disentangle the two effects.

If we could observe whether any two managers know and communicate with each other, constructing an empirical test would be straightforward. In the absence of such data, however, we rely on a unique identification strategy to uncover person-to-person relationships. We argue that managers who live near one another (“neighbors”) have a better chance of meeting|and subsequently becoming acquaintances or friends|than do managers who live further apart.4 For example, managers might meet at a neighborhood park or school, or while taking the train to work. The longer they live near each other, the more such opportunities to become friends will arise. And, having become friends, neighbors may have more ongoing interactions due to a higher probability of random encounters, or shared social connections through local schools or places of worship. Importantly, we are not suggesting that these random encounters are the main method for the transmission of ideas, but rather that they increase the probability of planned interactions.

Mutual Fund Portfolios

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