What alleviates crowding in factor investing?

Author / Creator

DeMiguel, Victor, author

Available as

Online

Summary

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 cr...

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.

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