What Alleviates Crowding in Factor Investing?
70 Pages Posted: 10 Jun 2019 Last revised: 27 Apr 2020
Date Written: May 9, 2019
Smart beta is a low-cost approach to factor investing that exploits common firm characteristics. The growing number of smart-beta providers raises concerns that crowding may increase price-impact costs and erode profits. We show crowding is alleviated by trading diversification--other institutions exploit strategies that, when implemented concurrently with the smart-beta strategy, reduce its price impact. Surprisingly, trading diversification occurs even when the trades of the other strategies are not negatively correlated with smart-beta trades. We show theoretically and empirically that, unlike the effect of competition in smart-beta, competition among institutions exploiting other strategies increases smart-beta profits because of trading diversification.
Keywords: financial institutions, capacity of quantitative strategies, price impact, competition, liquidity provision
JEL Classification: G11, G12, G23, L11
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