How to beat the crowd in factor investing

Can factor investing continue to give investors an edge if everyone’s doing it?

Interest in using factors to invest has been on an upward trend and is still rising, says Alberto Martin-Utrera, an assistant professor of finance at the New Jersey Institute of Technology. “The assets under management have grown exponentially in the last decade, they went from about $50 billion in 2009 to almost $700 billion in 2018. And the number of investment institutions using this is on the rise.”

This trend calls into question whether investors should be worried about overcrowding within these strategies, he says. “The way we understand crowding is that when there are many investors, many financial institutions chasing the same investment opportunity, that will lead to over investment and that will push prices against them and that could potentially erode all the profits from these strategies.”

In a recent paper, Martin-Utrera, along with his co-authors, Victor DeMiguel, a professor of management science and operations at the London Business School and Raman Uppal, a professor of finance at the EDHEC Business School, asked whether investors could do anything about the risk of crowding among factors.

“What we explain is that when investors use two different factor strategies, they can reduce each other’s price-impact costs, which are transaction costs that are going to affect the profits from investing in a particular investment strategy.”

The mechanism, which he calls trading diversification, is most intuitively employed using factors that are negatively correlated, he says. If the balancing trades are negatively correlated, then on average, they will net each other out.

Using both value and momentum factors, for example, could prompt investors toward buying and selling the same stock, he says. But there are still price-impact benefits even when the trades are uncorrelated. “When the rebalancing trades are uncorrelated or mildly correlated, there are still trading diversification benefits from exploiting factor investing or smart beta strategies simultaneously.”

The paper was presented at the Northern Finance Association’s 2020 conference. The Canadian Investment Review is a proud partner of the NFA conference.