What Alleviates Crowding in Factor Investing?

Raman Uppal, Victor DeMiguel and Alberto Martin-Utrera

No 16527, CEPR Discussion Papers from C.E.P.R. Discussion Papers

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. Using mutual-fund holdings, we provide empirical support for the model's predictions.

Keywords: Capacity of quantitative strategies; Price impact; Competition (search for similar items in EconPapers)
JEL-codes: G11 G12 G23 L11 (search for similar items in EconPapers)
Date: 2021-09
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