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What the drop in Valeant’s stock says about hedge funds’ herd mentality

Hedge fund manager Bill AckmanHedge fund manager Bill Ackman
Hedge fund manager Bill Ackman.Photograph by David A.Grogan—CNBC/NBCU/Photo Bank via Getty Images

Bill Ackman, the famously outspoken hedge fund manager, has lost roughly $2 billion, on paper, on his investment in Valeant, the controversial drug company that plunged this past week after a short seller compared it to Enron. It was Ackman’s fund’s largest holding.

But he is certainly not alone among the losers. A number of large hedge funds were also significant holders of Valeant as recently as the middle of the year. Among the others who could be out big bucks are the funds of John Paulson, who made billions betting against the housing market, and activist investor Jeff Ubben, whose ValueAct fund had been selling shares of Valeant this year but still owned nearly 15 million shares of the company as of the middle of 2015. Both Lone Pine Capital and Viking Global, two of the world’s largest hedge funds, which have well over $20 billion in assets each, also held Valeant (VRX) shares.

Of the thousands of stocks in the market, Valeant had the distinction of being held by a large number of hedge funds. Of the 1,000 hedge funds tracked by Symmetric.IO, roughly 12% owned shares of Valeant. In all, 32% of Valeant’s shares were held by hedge funds. As of August, it ranked No. 12 on Goldman’s list of the favorite stocks of hedge fund managers.

Hedge funds pride themselves, and justify their large fees, by saying they do tons of research and find investments off the beaten path. But in the past few years, it seems more and more hedge fund managers own more of the same stocks. And that could be a problem.

“There is some … herd mentality in hedge fund land,” says Jonathan Liggett, a financial advisor who helps clients pick hedge funds. “They share investment philosophies and often the same stocks.”

With Valeant, Liggett says Ackman probably set a trend that other funds followed. Liggett says hedge fund managers often pour over the lists of stocks that are owned by some of the top hedge fund managers, and choose their positions from there. “Ackman certainly attracts followers.”

The copycat behavior may also be related to the growth of the hedge fund industry. As more funds set up shop, there may be fewer novel positions out there. And as more money is invested in hedge funds, even more funds may start to look alike.

Symmetric recently did a study of hedge fund concentration, and it found that, among all hedge funds, portfolio overlap tends to be relatively small. But they also found that “a bunch of really well known funds … have basically the same positions,” says Symmetric’s Sam Abbas. For instance, Lone Pine Management shared four of the top 10 picks of Tiger Global, the hedge fund run by Chase Coleman, who is famous for his early investment in Facebook (FB).

This could be a problem for individuals or pension funds that invest in hedge funds. They could end up not as diversified as they think. What’s more, hedge funds might have trouble justifying their high fees if they are holding the same stocks as a rival.

Such imitative investing behavior could also be a problem for investors in general. When hedge funds pile into the same stock, it tends to makes those stocks, and the market overall, more volatile. It drives up the prices of stocks and tends to make them more susceptible to big swings when bad news happens. That’s what we have seen with Valeant, whose shares have dropped 50% in the past month, as the company faces investigations into its drug pricing policies and, in the past week, allegations that it uses affiliated specialty drug distributors to inflate sales. Valeant denies it has done anything wrong. It is holding a conference call on Monday to address the issues.

But if it turns out that Valeant is a fraud akin to Enron, the so-called smart money that has piled into the stock en masse, will look pretty dumb.