Introducing Venn’s Crowding

Factor

Venn highlights an approach to capturing

“ Crowding as a factor in the Two Sigma Factor
Lens and explor......

Seeing through the crowd

What is Crowding?
Crowding is the phenomenon whereby several investment
managers, knowingly or unknowingly, hold the same positions in
their investment portfolios. As formerly unique investment
strategies become more known amongst managers, either due to
independent research efforts or movement of talent across firms,
more capital is deployed into them. Given limited alpha
opportunities and the scarcity of differentiated alpha, it’s not

surprising that investment managers deploy similar strategies. As

a result, it’s common for a given strategy’s Sharpe ratio to
gradually degrade and for its tail risk to increase. However, in
other cases, such as for trend following strategies , crowding can
result in a positive feedback loop that results in a higher Sharpe
ratio.1
Why Does Crowding Exist?
Crowding exists for a number of reasons, including but not
limited to:
1. Similarity in the ideas and thought processes of
investment professionals across firms. This tends to be
more prominent amongst discretionary investors.
2. Similarity in the data sets and other sources of
information that are commonly used to build investment
strategies.
3. Commoditization of what previously were lesser-known
and harder-to-access investment ideas and meaningful
capital participation in funds that capture them. Examples
include smart beta ETFs and thematic ETFs that now
offer opportunities for retail and institutional investors to
access strategies that were once only available on an
exclusive basis.
4. Visibility, on a lagged basis, into specific long positions of
managers made available through public Form 13Fs that
make “copycat” or replication strategies possible.
An Approach to Measuring Crowding
Given that the aggregate portfolio of investors cannot be
precisely known, it is common to leverage market variables that
may be indicators of investor views. For publicly traded equities,
one such market variable is the short utilization ratio. A stock’s
short utilization ratio is the ratio of the number of its shares that
are currently sold short to the total number of shares available to
borrow. In other words, this ratio captures the percentage of
shares available to be shorted that have been put to work. As
this ratio increases, the possibility that the broader investment
community is holding this stock short in their aggregate portfolio
also increases.
Motivation for Crowding on Venn
One of the reasons for the presence of crowding in investor
portfolios is the possibility of common hedge fund investment
strategies becoming known to a wider set of market participants.
Equity style factors, such as the ones included in the Two Sigma
Factor Lens, have become well-known across the investment
community. It is now reasonable to expect most equity
investment managers to be trading some variation of these
factors, thus, potentially making these factors crowded.
Therefore, the aggregate investment portfolio will likely contain
exposure to the current equity style factors in the Two Sigma
Factor Lens. Venn’s risk and returns attribution methodology,
when applied to a given manager’s returns, is designed to show
the risk and return attributed to following the Momentum,
Quality, Value, Low Risk and Small Cap investment styles.
Given the plethora of dynamics contributing to crowding in
markets, we were interested in capturing the crowding in a
manager’s portfolio above and beyond what could be captured
by today’s five equity style factors. As many of our subscribers
invest in hedge funds, we chose to start with measuring
crowding in global equities as represented by the short utilization
ratio. To construct our crowding factor, we create a market
neutral portfolio that is short global stocks with high short
utilization ratios and long stocks with low short utilization ratios.
Venn’s Crowding Factor
Our Crowding factor, constructed as outlined above, evidences a
positive long-term return, similar to most of the other equity
style factors in the Two Sigma Factor Lens. Two likely
explanations for this strong historical performance include: the
sophisticated and informed investors behind these short
positions and compensation for the risk of massive liquidations
of the commonly held short positions.
Figure 1: Cumulative Return of Crowding Since Inception
Source: Venn. Time period: January 2008 - May 2020.

When used to analyze the performance of 14,000+ hedge funds

from Lipper TASS, the Crowding factor was commonly included
in factor analysis results and appears to be as explanatory as
Venn’s existing equity style factors, as illustrated by Figures 2
and 3 below.
Figure 2: Percentage of Hedge Fund Factor Analyses that Include
Equity Style Factors
Sources: Venn and Lipper TASS. Time period: January 2008 -
May 2020.
Figure 3: Average Percentage of Hedge Fund Risk Explained by
the Equity Style Factors
Sources: Venn and Lipper TASS. Time period: January 2008 -
May 2020.

On the other hand, when analyzing the performance of 6,000

mutual funds, the Crowding factor was not found to have
meaningful explanatory power. Mutual funds are typically not
allowed to engage in shorting of stocks, which diminishes their
ability to have a direct influence on the short utilization ratios of
stocks, the measure on which our Crowding factor is built.
Figure 4: Percentage of Mutual Fund Analyses that Include Equity
Style Factors
Sources: Venn and Morningstar. Time period: January 2008 -
May 2020.

Figure 5: Average Percentage of Mutual Fund Risk Explained by

the Equity Style Factors
Sources: Venn and Morningstar. Time period: January 2008 -
May 2020.
The figures above suggest that our new Crowding factor is a
common and meaningful driver of risk in hedge funds. Given that
the current iteration of the factor is driven by the short utilization
ratio of stocks, the Crowding factor is less relevant for mutual
funds, who tend not to participate in short selling.
We are excited to make our new Crowding factor available to all
subscribers and hope that you find it valuable in your evaluation
of managers and portfolios!

REFERENCES

1 De Long, J.B., Shleifer, A., Summers, L.H. and Waldmann, R.J.

(1990), Positive Feedback Investment Strategies and
Destabilizing Rational Speculation. The Journal of Finance, 45:
379-395. doi:10.1111/j.1540-6261.1990.tb03695.x
This article is not an endorsement by Two Sigma Investor
Solutions, LP or any of its affiliates (collectively, “Two Sigma”) of
the topics discussed. The views expressed above reflect those of
the authors and are not necessarily the views of Two Sigma. This
article (i) is only for informational and educational purposes, (ii)
is not intended to provide, and should not be relied upon, for
investment, accounting, legal or tax advice, and (iii) is not a
recommendation as to any portfolio, allocation, strategy or
investment. This article is not an offer to sell or the solicitation of
an offer to buy any securities or other instruments. This article is
current as of the date of issuance (or any earlier date as
referenced herein) and is subject to change without notice. The
analytics or other services available on Venn change frequently
and the content of this article should be expected to become
outdated and less accurate over time. Any statements regarding
planned or future development efforts for our existing or new
products or services are not intended to be a promise or
guarantee of future availability of products, services, or
features. Such statements merely reflect our current plans.
They are not intended to indicate when or how particular
features will be offered or at what price. These planned or future
development efforts may change without notice. Two Sigma has
no obligation to update the article nor does Two Sigma make any
express or implied warranties or representations as to its
completeness or accuracy. This material uses some trademarks
owned by entities other than Two Sigma purely for identification
and comment as fair nominative use. That use does not imply
any association with or endorsement of the other company by
Two Sigma, or vice versa. See the end of the document for other
important disclaimers and disclosures. Click here for other
important disclaimers and disclosures.
This article may include discussion of investing in virtual
currencies. You should be aware that virtual currencies can have
unique characteristics from other securities, securities
transactions and financial transactions. Virtual currencies prices
may be volatile, they may be difficult to price and their liquidity
may be dispersed. Virtual currencies may be subject to certain
cybersecurity and technology risks. Various intermediaries in the
virtual currency markets may be unregulated, and the general
regulatory landscape for virtual currencies is uncertain. The
identity of virtual currency market participants may be opaque,
which may increase the risk of market manipulation and fraud.
Fees involved in trading virtual currencies may vary.

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