DP16527 What Alleviates Crowding in Factor Investing?
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.