Crowded Trades and Tail Risk

56 Pages Posted: 13 Feb 2019 Last revised: 4 Jun 2019

See all articles by Gregory W. Brown

Gregory W. Brown

University of North Carolina (UNC) at Chapel Hill - Finance Area

Philip Howard

Wake Forest University - School of Business; University of North Carolina (UNC) at Chapel Hill - Frank Hawkins Kenan Institute of Private Enterprise

Christian T. Lundblad

University of North Carolina Kenan-Flagler Business School

Date Written: June 2, 2019

Abstract

A growing body of research examines the implications of common holdings for asset price determination; however, far less is known about the impact of hedge fund ownership concentration on risk and return. Yet, hedge fund positions are an important component of the degree of crowdedness because these investment vehicles tend to be particularly active in their pursuit of outperformance, they often take highly concentrated positions, and they utilize leverage and short sales. Using a large database of U.S. equity position-level holdings for hedge funds, we measure the degree of security-level crowdedness. We construct a new factor by taking the difference between returns of high and low crowdedness portfolios. The average return on the crowdedness factor is sizable, and its variation is distinct from other traditional risk factors for U.S. equities. When hedge fund returns are regressed onto other risk factors and the crowdedness factor, the exposures to crowdedness are often statistically and economically significant in explaining hedge fund return variation. Most important, the crowdedness factor is related to downside "tail risk" as stocks with higher exposure to crowdedness experience relatively larger drawdowns during periods of market distress. This tail risk extends to hedge fund portfolio returns as the crowdedness factor explains why some funds experience relatively large drawdowns or even death.

Keywords: Hedge Fund, Crowded Trade

JEL Classification: G11, G23

Suggested Citation

Brown, Gregory W. and Howard, Philip and Lundblad, Christian T., Crowded Trades and Tail Risk (June 2, 2019). Available at SSRN: https://ssrn.com/abstract=3326802 or http://dx.doi.org/10.2139/ssrn.3326802

Gregory W. Brown

University of North Carolina (UNC) at Chapel Hill - Finance Area ( email )

Kenan-Flagler Business School
Chapel Hill, NC 27599-3490
United States

Philip Howard

Wake Forest University - School of Business ( email )

Farrell Hall 363
1834 Wake Forest Rd
Winston-Salem, NC 27109
United States

HOME PAGE: http://sites.google.com/view/pdwhoward

University of North Carolina (UNC) at Chapel Hill - Frank Hawkins Kenan Institute of Private Enterprise ( email )

Campus Box 3440, The Kenan Center
Chapel Hill, NC 27599-344
United States

Christian T. Lundblad (Contact Author)

University of North Carolina Kenan-Flagler Business School ( email )

Kenan-Flagler Business School
Chapel Hill, NC 27599-3490
United States
919-962-8441 (Phone)

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