Seeing through the crowd

WHAT IS CROWDING?

Crowding is the phenomenon whereby several investment managers, knowingly or unknowingly, hold the same positions in their investment portfolios. As formerly unique investment strategies become more known amongst managers, either due to independent research efforts or movement of talent across firms, more capital is deployed into them. Given limited alpha opportunities and the scarcity of differentiated alpha, it’s not surprising that investment managers deploy similar strategies. As a result, it’s common for a given strategy’s Sharpe ratio to gradually degrade and for its tail risk to increase. However, in other cases, such as for trend following strategies, crowding can result in a positive feedback loop that results in a higher Sharpe ratio.1

 

WHY DOES CROWDING EXIST?

Crowding exists for a number of reasons, including but not limited to:

  1. Similarity in the ideas and thought processes of investment professionals across firms. This tends to be more prominent amongst discretionary investors.
  2. Similarity in the data sets and other sources of information that are commonly used to build investment strategies.
  3. Commoditization of what previously were lesser-known and harder-to-access investment ideas and meaningful capital participation in funds that capture them. Examples include smart beta ETFs and thematic ETFs that now offer opportunities for retail and institutional investors to access strategies that were once only available on an exclusive basis.
  4. Visibility, on a lagged basis, into specific long positions of managers made available through public Form 13Fs that make “copycat” or replication strategies possible.

 

AN APPROACH TO MEASURING CROWDING

Given that the aggregate portfolio of investors cannot be precisely known, it is common to leverage market variables that may be indicators of investor views. For publicly traded equities, one such market variable is the short utilization ratio. A stock’s short utilization ratio is the ratio of the number of its shares that are currently sold short to the total number of shares available to borrow. In other words, this ratio captures the percentage of shares available to be shorted that have been put to work. As this ratio increases, the possibility that the broader investment community is holding this stock short in their aggregate portfolio also increases.

 

MOTIVATION FOR CROWDING ON VENN

One of the reasons for the presence of crowding in investor portfolios is the possibility of common hedge fund investment strategies becoming known to a wider set of market participants.

 

Equity style factors, such as the ones included in the Two Sigma Factor Lens, have become well-known across the investment community. It is now reasonable to expect most equity investment managers to be trading some variation of these factors, thus, potentially making these factors crowded. Therefore, the aggregate investment portfolio will likely contain exposure to the current equity style factors in the Two Sigma Factor Lens. Venn’s risk and returns attribution methodology, when applied to a given manager’s returns, is designed to show the risk and return attributed to following the Momentum, Quality, Value, Low Risk and Small Cap investment styles.

 

Given the plethora of dynamics contributing to crowding in markets, we were interested in capturing the crowding in a manager’s portfolio above and beyond what could be captured by today’s five equity style factors. As many of our subscribers invest in hedge funds, we chose to start with measuring crowding in global equities as represented by the short utilization ratio. To construct our crowding factor, we create a market neutral portfolio that is short global stocks with high short utilization ratios and long stocks with low short utilization ratios and residualize it against the other Equity Style factors.

 

VENN’S CROWDING FACTOR

Our Crowding factor, constructed as outlined above, evidences a positive long-term return, similar to most of the other equity style factors in the Two Sigma Factor Lens. Two likely explanations for this strong historical performance include: the sophisticated and informed investors behind these short positions and compensation for the risk of massive liquidations of the commonly held short positions.

Figure 1: Cumulative Return of Crowding Since Inception

Source: Venn. Time period: January 2008 - May 2020.

Cumulative Return of Crowding Since Inception

 

When used to analyze the performance of 14,000+ hedge funds from Lipper TASS, the Crowding factor  was commonly included in factor analysis results and appears to be as explanatory as Venn’s existing equity style factors, as illustrated by Figures 2 and 3 below.

 

Figure 2: Percentage of Hedge Fund Factor Analyses that Include Equity Style Factors

Sources: Venn and Lipper TASS. Time period: January 2008 - May 2020.

Percentage of Hedge Fund Factor Analyses that Include Equity Style Factors

 


Sign up for Venn to view your portfolio's exposures to these factors.


Figure 3: Average Percentage of Hedge Fund Risk Explained by the Equity Style Factors

Sources: Venn and Lipper TASS. Time period: January 2008 - May 2020.

Average Percentage of Hedge Fund Risk Explained by the Equity Style Factors

 

On the other hand, when analyzing the performance of 6,000 mutual funds, the Crowding factor was not found to have meaningful explanatory power. Mutual funds are typically not allowed to engage in shorting of stocks, which diminishes their ability to have a direct influence on the short utilization ratios of stocks, the measure on which our Crowding factor is built. 

 

Figure 4: Percentage of Mutual Fund Analyses that Include Equity Style Factors

Sources: Venn and Morningstar. Time period: January 2008 - May 2020.

Percentage of Mutual Fund Analyses that Include Equity Style Factors



Figure 5: Average Percentage of Mutual Fund Risk Explained by the Equity Style Factors

Sources: Venn and Morningstar. Time period: January 2008 - May 2020.

Average Percentage of Mutual Fund Risk Explained by the Equity Style Factors

 

The figures above suggest that our new Crowding factor is a common and meaningful driver of risk in hedge funds. Given that the current iteration of the factor is driven by the short utilization ratio of stocks, the Crowding factor is less relevant for mutual funds, who tend not to participate in short selling.

 

We are excited to make our new Crowding factor available to all subscribers and hope that you find it valuable in your evaluation of managers and portfolios!

 

REFERENCES

1 De Long, J.B., Shleifer, A., Summers, L.H. and Waldmann, R.J. (1990), Positive Feedback Investment Strategies and Destabilizing Rational Speculation. The Journal of Finance, 45: 379-395. doi:10.1111/j.1540-6261.1990.tb03695.x

 

This article is not an endorsement by Two Sigma Investor Solutions, LP or any of its affiliates (collectively, “Two Sigma”) of the topics discussed.  The views expressed above reflect those of the authors and are not necessarily the views of Two Sigma. This article (i) is only for informational and educational purposes, (ii) is not intended to provide, and should not be relied upon, for investment, accounting, legal or tax advice, and (iii) is not a recommendation as to any portfolio, allocation, strategy or investment.  This article is not an offer to sell or the solicitation of an offer to buy any securities or other instruments. This article is current as of the date of issuance (or any earlier date as referenced herein) and is subject to change without notice. The analytics or other services available on Venn change frequently and the content of this article should be expected to become outdated and less accurate over time.  Two Sigma has no obligation to update the article nor does Two Sigma make any express or implied warranties or representations as to its completeness or accuracy. This material uses some trademarks owned by entities other than Two Sigma purely for identification and comment as fair nominative use. That use does not imply any association with or endorsement of the other company by Two Sigma, or vice versa. See the end of the document for other important disclaimers and disclosures. Click here for other important disclaimers and disclosures.

Recent Posts