Can Competition Increase Profits in Factor Investing?

Abstract

The increasing number of institutions exploiting factor-investing strategies raises concerns that competition may erode profits. We use a game-theoretic model to show that, while competition among investors exploiting a particular factor erodes profits because of the negative externality of their price impact on each other, competition to exploit other factors can increase profits from the first factor because of the positive externality from trading diversification (netting of trades across factors). Using data for 18 factors as well as mutual-fund holdings, we show that competition and trading diversification substantially affect the profits from factor investing.

Keywords: capacity of quantitative strategies, crowding, price impact.

JEL Classification: G11, G12, G23, L11