The Price Impact of Institutional Herding

We develop a simple model of the price impact of institutional herding. The empirical literature indicates 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 trade with security dealers endowed with market power and exhibit an endogenous tendency to imitate past trades. This tendency is exploited by dealers and thus affects prices. In equilibrium, institutional herding positively predicts short-term returns but negatively predicts long-term returns. Our article also generates several new, testable predictions that link institutional herding with the time-series properties of returns and volume.