How to spot Crowded Trades
The “quant meltdown” of August 2007 and the subsequent unfolding of the global financial crisis highlighted the risks of crowded investment strategies. The rapid growth of smart beta indexes and their use in ETFs has added to the need for scrutiny.
In “ Lost in the Crowd? Identifying and Measuring Crowded Strategies and Trades”, we propose a set of four key metrics - our “Crowding Scorecard”- for monitoring and detecting the potential crowding risk for any investment strategy. This work builds upon our innovative analysis of the historical behaviors of investment strategies and MSCI’s next generation equity risk models which incorporate Systematic Equity Strategies (SES).
The first two measures help capture crowding activity in the trading activity of various market participants, such as Value and Growth Managers, and pinpoint the overlap in trading activity of otherwise heterogeneous investors. The last two measures capture the pricing and valuation impacts of such trading activity. Both sets of measures are essential in developing a crowding scorecard.
The MSCI Crowding Scorecard can be applied to single stocks, indexes and active strategies, making it an important tool for investment and risk managers following both quantitative and fundamental strategies- including the recently popular factor index approaches. Using a Crowding Scorecard can help managers understand the risks of overlaps in trading strategies that may not be apparent by focusing on one of these metrics alone.
Worried About Overcrowded Trades? Try These Charts
Mehmet Bayraktar, head of equity research at MSCI, explains his system for spotting a trade before it becomes overcrowded. He speaks on “Market Makers.” (Source: Bloomberg)