What Alleviates Crowding in Factor Investing?
69 Pages Posted: 22 Sep 2021
There are 2 versions of this paper
Can Competition Increase Profits in Factor Investing?
Date Written: September 2021
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. Using mutual-fund holdings, we provide empirical support for the model's predictions.
Keywords: capacity of quantitative strategies, Competition, price impact
JEL Classification: G11, G12, G23, L11
Suggested Citation: Suggested Citation