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). We calibrate our model using the investment and profitability factors and find that competition to exploit the profitability factor leads to a 68% increase in the capacity and a 143% increase in the profit from the investment factor.

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

JEL Classification: G11, G12, G23, L11