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that too many other investors are also exposed
to. Topical examples are some US biotechnology
and social media stocks, where crowding has led
to valuations so extreme that the whole market
Australia has experienced crowded trades of
its own in recent years – most notably in the
government bond market, where global investors
sought refuge from zero interest rates in the US
and sovereign debt crises in the euro area, and
this drove Commonwealth yields to historic lows.
Similarly, in the share market, risk aversion pushed
valuations of defensive stocks unusually high.
The risk for investors in a crowded trade, of
course, is that they will be unable to reach the exits
when the ‘fire alarm’ sounds; that, when the stock
falls from favour, their actions and those of others
trying to sell at the same time will cause illiquidity
in the stock and this will lead to financial loss.
Not all crowded trades necessarily end this way,
but investors should consider attaching as much
importance to crowding as they do currently to
Ukraine and the other risks mentioned earlier.
This is because crowding, in my view, is the single
biggest unrecognised risk in most portfolios
today. To understand why, it helps to know a little
about crowding’s recent history.
RECOGNISING A CROWDED TRADE
Crowding has always existed, often viewed as a
favourable indicator of a stock’s worth. It revealed
itself as a problem after 2008, however, when
investors began paying more attention to risk; ‘risk
aware’ investment products became popular and
capital flowed from active to passive managers.
Hence the insidious nature of crowding
alluded to earlier: it’s relatively easy for investors
to become exposed to crowding as a result of
taking actions they believe will actually mitigate
risk, for example, by buying stocks that are widely
regarded as ‘safe’ during periods of uncertainty.
This poses the first question: how do you
recognise a crowded trade? You need to know
where to look, and you need to know what
you’re looking for. In terms of where to look, five
factors may help investors determine whether or
not a stock is crowded (see the table).
Note that the first two factors are ownership-
related and the remaining three are related to the
sell side or investor sentiment. The first two create
the risk of a crowded stock becoming illiquid, as
very wide or long-term institutional ownership of a
stock may lead to a shortage of marginal buyers.
With regard to the other factors, investors tend
to become attached to high-momentum companies
that have outperformed over extended periods,
while sell-side analysts can also be swept along
by enthusiasm for particular stocks. Lastly, bullish
earning expectations tend to feed themselves.
If any of the stocks in your fund exhibit these
characteristics, the chances are they’re crowded.
“So what?” you may say. “Why should I care?”
One reason is that our research suggests crowded
stocks tend to exhibit four undesirable traits that
can materially affect an investor’s experience.
The first is that crowded companies tend to
become more volatile than they have been in
the past. This means that they might represent
a much higher portion of your total risk budget
than you expect (in other words, crowded
positions disproportionately affect overall
Secondly, crowded stocks are prone to perform
badly during large market moves or inflection
points. When the market move is positive, the
stocks underperform because of the scarcity of
incremental buyers; when negative, the stocks
suffer from numerous owners wishing to sell.
Thirdly, crowded stocks respond in particular
ways to earnings revisions. Positive revisions
typically have little impact (owners’ expectations
are, almost by definition, already positive), but a
negative revision is likely to elicit a much sharper
reaction. This is also true in the case of other
adverse developments such as the departure of
the chief executive officer or the emergence of a
Fourthly, crowded stocks tend to respond to
changes in sentiment and capital flows related to
their crowding theme. This creates a differentiated
risk profile, with low correlation to the market and
high correlation to similar crowded stocks, which
may not be captured by a portfolio’s risk model.
This brings us to the next question: just
how vulnerable to crowding risk is the average
Australian superannuation fund likely to be?
MANAGING THE RISK
Some generalisation is necessary here, but it’s
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