Working Paper: CEPR ID: DP16527
Authors: Victor Demiguel; Alberto Martin Utrera; Raman Uppal
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
JEL Codes: G11; G12; G23; L11
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| competition among institutions exploiting different characteristics (D29) | alleviates crowding effect (D61) |
| trading diversification can alleviate crowding (F12) | reduces price impact costs (G19) |
| trading diversification (F19) | total capacity (E22) |
| trading diversification (F19) | optimal investment (G11) |
| trading diversification (F19) | annual profits (D33) |