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

Many investors combine concerns over overcrowding in factors with capacity fears. We want to help separate these terms and provide some clarity over the current state of factors.

On the basis of valuations, more risk-averse investors may believe that factors are overcrowded. We believe though that there are a few more spare tables at this café. The problem of capacity is more acute for investors’returns. However, if investors were to allow their index fund manager more leeway in tracking error or employ a manager who can estimate and manage the costs more effectively, the capacity threshold could be raised.
Overcrowding and capacity in factor-based investing: Should we be worried?

The difference between the following definitions is nuanced but critical. Capacity tends to be more rooted in fact, whereas overcrowding is 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 queuers,is wrong. They are simply different results driven by individual preferences or feelings of hunger, patience, or perhaps the draw of this particular establishment.

An 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 the rules-based factor index products.

Table 1 below shows statistics of a few low volatility strategies relative to a market cap-weighted parent. The factor, and strategies attempting to gain exposure to it, has performed as intended. However, this does not mean that those warning of low volatility overcrowding were incorrect; rather their personal preference, based on risk tolerance, was such that they would not recommend further investment for like-minded individuals.

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