Examining Passive Crowding as a Risk Factor
Authors: Farhan Mustafa, CFA, Head of Quantitative Research, Head of Risk Management, ClearBridge Investments; Barath Balu, CFA, Quantitative Research Associate, ClearBridge Investments
Since equity markets have no way of systematically distinguishing between trades placed by informed active managers and valuation-agnostic passive funds, it stands to reason that the market might mistakenly adjust its assessment of a security’s intrinsic value in response to changes in ownership by passive funds. This should, in theory, lead to mispricings that active managers can exploit.
Our backtests show that passive crowded securities — those that have experienced comparatively large increases in ownership by passive ETFs and index mutual funds — tend to exhibit significantly lower forward returns than passive uncrowded stocks. Most of the alpha generated by this passive crowding factor is derived from the underperformance of passive crowded stocks, making it most suitable as an exclusionary criterion. Systematically managing a portfolio’s exposure to these securities should help deliver positive alpha.