Factor Crowding Model

Mob Management Measures

July 2018. Reading Time: 15 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Crowded factors exhibit higher drawdowns than uncrowded factors
  • A multi-metric approach can be successfully applied to measure factor crowding
  • Effective in reducing factor drawdowns and volatility, but less meaningful for returns

INTRODUCTION

Architects devoted to creating large public facilities like sports stadiums are tasked with finding a good balance between aesthetics, commercialism and safety. The latter mainly focuses on crowd control management as stampedes, crushes and riots can have tragic consequences. Crowds are the lifeblood of public arenas as well as one of the key risk factors.

In investing, crowds have the same characteristics as they are required to make an investment popular and drive its performance, but also represent risk if the trade is widely owned. Given the significant inflows into smart beta ETFs and risk premia strategies in recent years, a frequent investor concern is the crowding of common equity factors like value or momentum.

There are various approaches for measuring factor crowding and these can broadly be differentiated between being based on funds flows, stock ownership, short interest or market-derived indicators. The first three data sets are only available with weeks or months delay while market-derived indicators can be measured daily or even intra-day. In this white paper we introduce a factor crowding model based on market-derived indicators (read Measuring Factor Crowding via Valuations).

Monitoring factor risks is relevant for systematic investors dedicated to factor investing as well as for discretionary portfolio managers. Factor investors are naturally interested in improving the risk-return ratios of their portfolios while discretionary portfolio managers are likely inclined to reduce any systematic risks not associated with their investment thesis.

MODEL OBJECTIVES

Crowding typically refers to periods of investments like equity factors that have received significant inflows and are held by a large part of the investment community. The risk of owning a popular factor is that a sudden change in market sentiment may result in many investors simultaneously reducing their f