Crowded trade risks, while often unappreciated by investors, can be real and significant. They can be viewed as a byproduct of the immense proliferation of index and index-like products. While these products meet important investor needs, their predominance has led to market conditions that can greatly intensify selloffs-and could expose equity managers to greater than expected losses in the event of a market downturn.
What can managers do to beef up their risk management chops? We discuss three analytic techniques investors can use (deployed here at FIS) to identify and manage the risks associated with crowded trades. This is an important risk management step for both allocators and portfolio managers as the stock market will always create surprises, especially in volatile markets.
While the market started the year strong, the preeminent market feature over the past few months has been the rise in volatility. Regardless of the cause, the VIX, the most common measure of market volatility, has risen from its record lows of below 11 to as high as 17 in recent months. The rise in volatility has included several large single day drops which caught some investors off guard and forced them to make adjustments to their risk management practices.
One area in need of focus from risk managers that is particularly susceptible to high volatility environments is the risk associated with “crowded trades.” Crowded trades occur when many market participants trade the same security or securities while employing the same or similar strategy. In other words, many people trade the same stock for the same reason. While this can drive the price of a stock up during the accumulation phase, this can also create liquidity shortages that create forced selling at fire sale prices when that same stock moves out of favor.
One of the best known examples of this type of market dislocation occurred in August 2007 when many quantitative strategies suffered losses. It turned out that the strategies were all using similar factors to identify stocks, so that when those factors fell out of favor, there was a mass rush to the exit door. This drained the liquidity of affected positions and caused larger losses than most investors expected.
Today’s stock market is even more complex than in 2007 as there has been substantial growth of investment products which make buy and sell decisions by grouping stocks with similar attributes or factors together. This creates an environment in which a few large players can dominate a stock’s liquidity and exacerbate crowding risk.