Comment by Professor Blake Lebaron

Blake LeBaron Professor at the Brandeis International Business School

Hedge funds the global warming of markets? The increased presence of hedge funds chasing similar investment strategies has the potential to cause severe gyrations in the markets, according to research conducted by Blake LeBaron of Brandeis University's International Business School. LeBaron is one of a handful of academics worldwide who creates and observes artificial financial markets.

Much like weather forecasters use sophisticated computers to track and try to predict the movements of hurricanes, LeBaron's models enter various variables to see how financial markets behave under different conditions.

"The connections are very strong between weather data modeling and what we do," LeBaron said. "We're not up to the accuracy of weather modeling, but we're getting there. Our artificial markets and the way they behave look very close to real ones."

And, just as studies show that global warming has increased the intensity of hurricanes, LeBaron's research shows that markets gyrate more wildly as hedge funds play a bigger role in them.

"There's a significant strategic difference between hedge funds and mutual funds," he explains. "Mutual funds tend to be long in equity and bond markets. Hedge funds can have very sophisticated strategies. When they follow similar strategies, we see instances where markets became unstable, and I can't seem to stop that from happening in my artificial models."

"The models I've developed are of increasing interest to investment banks because they tell us something about liquidity in financial markets and the impact of different strategies," he says. "Liquidity measures are driven by investment strategies. And, if those strategies are very similar, then markets become very unstable. I see a lot of that instability in simulated markets."

As human decision-making becomes a lesser component of trade execution, equity markets are becoming easier to model, but also more prone to severe fluctuations.

"A few financial institutions are setting up artificial markets themselves," he says. "More significantly, many real-world strategies developed are applied mechanically, through algorithmic trading. You may have a human being saying 'we're going into XYZ stock,' but they have a machine doing the trading. The volume on any given day is increasingly machine driven."

Another reason for the growing interest in artificial market modeling, as well as a complicating factor in doing so accurately, is the realization among a majority of academics and practitioners that markets aren't rational. To quote Warren Buffett: "I'd be a bum on the street with a tin cup if the markets were always efficient."

"When you back away from rational markets, modeling becomes much more difficult," says LeBaron, who developed his first artificial market models at the Santa Fe Institute. "Rational people are much easier to model than 'crazy people.'"

So, the two big questions about 'crazy people' that LeBaron must account for and try to answer is this: will they make a difference in the aggregate level? And, will they disappear (i.e. run out of money)?

"It's not clear that it's good to be rational in a world full of crazy people," LeBaron says. "And, the crazy types seem to be able to create an environment in which they can survive."

Blake LeBaron's research on hedge funds was also covered by MoneyScience Finance News on December 5, 2005.

Blake LeBaron is the Abram L. and Thelma Sachar Chair of International Economics at the International Business School. He is a Research Associate at the National Bureau of Economic Research, and was a Sloan Fellow. LeBaron also served as director of the Economics Program at The Santa Fe Institute in 1993.