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What Alleviates Crowding in Factor Investing?

Author

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  • Uppal, Raman
  • DeMiguel, Victor
  • Martin-Utrera, Alberto

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.

Suggested Citation

  • Uppal, Raman & DeMiguel, Victor & Martin-Utrera, Alberto, 2021. "What Alleviates Crowding in Factor Investing?," CEPR Discussion Papers 16527, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:16527
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    More about this item

    Keywords

    Capacity of quantitative strategies; Price impact; Competition;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
    • L11 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Production, Pricing, and Market Structure; Size Distribution of Firms

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