Factoring crowdedness in risk management

Crowded stocks or trades show larger downside moves (drawdowns) especially in crisis periods. Liquidity constraints exacerbate these losses. These effects are not just small noise but could lead to materially worse performance during bad times increasing tail risk or downside exposure

There’re multiple factors that influence the outcome of the stock price movements and thus our returns. The biggest factor, however, is the behavior of the investor himself.

While most of the factors are ingrained, there could be a few which are market driven that bring up the behavior to the fore. Crowdedness refers to the phenomenon where many institutional or active investors hold similar positions (in stocks or factors), leading to high demand pressure on certain securities.

It is sometimes measured by institutional holdings relative to trading volumes or by overlapping positions across fundsor by “crowded trades” in hedge funds and their exposures.

The concept treats demand-side effects (which stocks / factor exposures investors favor) as a risk driver.If many are exposed, downside moves (liquidity, sentiment, flows) can amplify the decline. It is akin to the herd mentality displayed during the market frenzy, which drives extreme market outcomes.

When too much money flows into same strategies, it could lead to bubbles. A team of BlackRock researchers addressed this in the Spring 2025 issue of The Journal of Beta Investment Strategies.

The study - A demand-based equity risk factor: Crowdedness, provides insights into how crowded trades can systematically impact stock returns and portfolio performance.

Crowdedness is a distinct risk factor which explains the variation in returns beyond the traditional factors (size, value, momentum, etc.). Stocks (or portfolios) with higher crowdedness tend to have lower future returns (all else equal), or at least greater risks of drawdowns.

Those securities, in particular, that are heavily ownedby hedge funds or active managers (relative to trading volume) tend to suffer more in periods of market stress.

The study addresses to quantify crowdedness in equity markets, if it becomes a systematic risk factor that affects stock returns and how investors could utilize crowdedness to improve portfolio construction & risk management.

Crowded stocks or trades show larger downside moves (drawdowns) especially in crisis periods. Liquidity constraints exacerbate these losses. These effects are not just small noise but could lead to materially worse performance during bad times increasing tail risk or downside exposure.

Over time, being in crowded trades tends to reduce excess returns (after adjusting for known factor exposures). In part due to “price impact” or demand being partially priced in, or because when things unwind, there is forced selling.

The crowdedness factor is measurable using public data (institutional holdings, fund disclosures) or trading‐flow data. This allows investors to monitor which stocks / sectors / factor exposures are crowded.Evidence suggests crowding has been increasing over time in some signals / strategies (e.g. momentum).

This factor has serious implications for risk assessment and portfolio construction when the portfolios might look cheap or attractive but hide large risk. So, investors should stress test for liquidity risk, margin calls, forced unwindings, etc. in crowded exposures. As more players pile into factor-based strategies, returns of them may decline leading to alpha decay.

Another outcome is the hurdles in trade execution as exits could become tough during pressured markets. Hence, true diversification must consider ‘crowding dimensions’ to reduce overlap of crowded trades.

To remedy this factor, investors should have internal monitoring to track increasing trend of institutional ownership relative to volume.

Impose limits on heavily owned stocks or factors or reduce leverage in them. This provides liquidity buffer and doesn’t cause too much price impact. Diversify to less crowded factors or trades to reduce overlap.

While it’s difficult to time the market, one should be aware of the market regime. Crowding effects tend to worsen in downturns, times of panic and during liquidity issues. So, one should be aware of early signs that can help reduce exposure proactively. The other way is to dynamically rebalance as the position becomes crowded.

Crowdedness is a priced risk factor, not just noise. Ignoring it can leave portfolios vulnerable to sudden drawdowns. By incorporating crowdedness into risk dashboards, treating it like any other factor (value, size, momentum), and enforcing limits/hedges when scores breach thresholds, portfolios could remain dynamic to risk.

(The author is a partner at “Wealocity Analytics”, a SEBI registered Research Analyst and could be reached at [email protected])