What Alleviates Crowding in Factor Investing?

Abstract

The growing number of institutions exploiting factor-investing strategies raises concerns that crowding may increase price-impact costs and erode profits. We identify a mechanism that alleviates crowding--trading diversification: institutions exploiting different characteristics can reduce each other's price-impact costs even when their rebalancing trades are not negatively correlated. Empirically, trading diversification increases capacity by 45%, optimal investment by 43%, and profits by 22%. Using a game-theoretic model, we show that, while competition to exploit a characteristic erodes its profits because of crowding, competition among institutions exploiting other characteristics alleviates crowding. Mutual-fund holdings provide empirical support for the model's predictions.

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

JEL Classification: G11, G12, G23, L11