Overcrowding and capacity in factor-based investing - Should we be worried?

As is often the case in financial markets, something offering an attractive risk and return profile is likely to invite further investment. Although generally indicative of success, additional attention for an investment strategy should be monitored to ensure that its expected risk and return potential persists – something that 'overcrowding' and 'capacity' issues can hamper.

Let's start by separating the terms overcrowding and capacity and aiming to provide some clarity over the current state of factors in investing.

Overcrowding: The presence of more people or things in a space than is comfortable, safe, or permissible.

Capacity: The maximum amount that something can contain

The difference between the definitions is nuanced but critical. Views on capacity tend to be more rooted in fact, whereas those on overcrowding are subjective. As such, the general trend is to talk of overcrowding of a market, or factors on the whole, and capacity of a fund or specific strategy.

If you’ve ever turned away from a café thinking “I can’t believe people are standing in that queue” and then gasped as six more people jump to the back, you can now consider yourself a witness to the results of inconsistent expectations. No one would argue that the rationale for you turning away, or that of the six additional people queuing, is wrong. They are simply different results driven by individual preferences or feelings of hunger, patience, or perhaps the draw of a particular establishment.

A financial example of this overcrowding/capacity dichotomy was in 2016, when many claimed that the low volatility factor was overcrowded and due for a crash. Some took to heart the many articles on this subject and others dismissed them as an attempt to derail the progress of rules-based factor index products.

Fast forward to mid-2018, and we haven’t seen the 'crash' quite yet. However, this does not mean that those warning of overcrowding in low volatility stocks were incorrect; rather their personal preference, based on risk tolerance, was such that they would not recommend further investment for like-minded individuals.

Evaluating overcrowding

Those attempting to establish a basis for factor crowding predictions often look to valuations as the metric of choice, typically using price-to-earnings measures. All else equal, logic dictates that if the price-to-earnings ratio of a group of stocks is higher today than it was a year ago, those stocks are more ‘expensive’. If we link in inflows (additional demand) for a factor exposure, then the conclusion that the proliferation of these products has caused stretched valuations is also logical. For the risk-averse, this fact may be the only burden of proof necessary to steer clear of further investment and perhaps even warrant divestment. Therein lies the complexity of financial markets.

Stock valuations are one method of evaluating the relative ‘richness/cheapness’ of a stock or group of stocks. If we can link a state of richness with excess demand via factor-based product proliferation, then we’re on our way to a more informed state of factor valuations. Unfortunately, this isn’t the whole story. The chart below shows high level flow data for the recent period encompassing the increased demand. What is interesting is the supply (i.e. source of inflows) and relative demand. With this vast disparity in place between market cap and factor-based index fund flows and the source of funds, it is hard to make the case that factors are overcrowded.

What about capacity?

Much like market cap-weighted portfolios, the capacity issue is apparent when an index has to rebalance. If all index investors have to buy and sell the same stocks on the same day, this can create notable price distortions and transaction costs will inevitably eat into returns.

The best way to reduce the impact and avoid eroding strategy returns is to increase the rebalance window. By spreading a portfolio rebalance over multiple trading days, fund capacity should increase dramatically. This should serve as a word of caution to index providers because they often only focus on overcrowding and conclude, incorrectly, that the capacity of an index-based strategy is enormous. There are three ways of attempting to minimise the effects of this natural consequence of index-based factor implementation, which in our view are increasingly more effective.

• Use an experienced index implementer capable of managing these risks
• Index providers can create multi-day rebalance strategies
• Investors could give the index manager a tracking-error bandwidth and take more risk around the review period

What's the bottom line?

On the basis of valuations, more risk-averse investors may believe that some factors are overcrowded. I believe though that there are a few more spare tables at this café. The problem of capacity is more acute for index investors’ returns. However, if investors were to allow their index fund manager more leeway, or employ managers who can estimate and manage the costs more effectively, capacity concerns could diminish.