What Alleviates Crowding in Factor Investing?

Abstract

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