Are Factor Strategies Overcrowded by ETF Investors ? Friday, 17 February, 2017
An interesting academic paper related to multiple equity factors:
Title: Are Exchange-Traded Funds Harvesting Factor Premiums?
Some exchange-traded funds (ETFs) are specifically designed for harvesting factor premiums, such as the size, value, momentum and low-volatility premiums. Other ETFs, however, may implicitly go against these factors. This paper analyzes the factor exposures of US equity ETFs and finds that, indeed, for each factor there are not only funds which offer a large positive exposure, but also funds which offer a large negative exposure towards that factor. On aggregate, all factor exposures turn out to be close to zero, and plain market exposure is all that remains. This finding argues against the notion that factor premiums are rapidly being arbitraged away by ETF investors, and also against the related concern that factor strategies are becoming ‘overcrowded trades’.
Notable quotations from the academic research paper:
"This paper investigates if factor premiums, such as the size, value, momentum and low-volatility premiums, are systematically being harvested by investors in exchange-traded funds (ETFs).
Using a comprehensive sample of US equity ETFs, this paper finds that there are many funds which offer a large positive exposure to target factors such as size, value, momentum and low-volatility. At the same time, however, there are also many funds which offer a large negative exposure towards these factors. On aggregate, the exposures towards the size, value, momentum and low-volatility factors turn out to be very close to zero.
The take-away from these results is that despite a large variation in factor exposures across funds, the only thing that remains when everything is added up is plain market beta exposure. This finding argues against the notion that factor premiums are rapidly being arbitraged away by ETF investors.
It also argues against the related concern that factor strategies may have become ‘overcrowded trades’. Many investors are concerned about overcrowding of factor strategies, although the concept is not clearly defined. The general idea behind factor overcrowding is that so many investors are chasing the same factors that the long-term premiums associated with these factors disappear, that valuations of the stocks in factor portfolios increase, and that correlations among the stocks in factor portfolios increase as well, which might result in elevated crash risk. As, from a factor investing perspective, there seems to be just as much ETF money chasing stocks with the wrong factor characteristics as ETF money chasing stocks with the right factor characteristics, the ETF market does not seem to justify factor overcrowding concerns."
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