Beware Crowding in Momentum Funds, Says MSCI

As the popularity of factor investing grows, the risks of overcrowding in some areas are also increasing.

Investors in momentum strategies should be wary of the risk of “crowding” among funds following the same strategy, MSCI has warned.

The index provider analysed a number of smart beta metrics using indicators of crowded trades such as correlations and valuation dispersion.“[Investors] may underestimate the aggregate amount of capital following similar strategies.” —MSCI

In a 33-page report, titled “Lost in the Crowd? Identifying and Measuring Crowded Strategies and Trades”, MSCI staffers Mehmet Bayraktar, Stuart Doole, Altaf Kassam, and Stan Radchenko found “there are reasons to be moderately concerned about crowding in the momentum factor”.

“Given the potential risks associated with such trading strategies, it is important for managers to identify and measure their crowding risk,” the authors added.

The research showed momentum factor funds were susceptible to the trading of mutual funds and hedge funds into and out of the strategy. In early 2009, MSCI said the “bounce-back” of some financial services stocks from the market bottom in March was “so significant that it resulted in one of the worst-ever historical performances of the momentum factor and momentum-based investment strategies”.

In addition, the authors warned that investors and managers launching factor-based funds should be aware of the capacity not only of their own funds but also of the wider market.

“Investors tend to employ reasonable capacity assumptions in pursuing their own strategy, but they may underestimate the aggregate amount of capital following similar strategies,” MSCI said. “In this case, stock prices may over- or under-shoot their fundamental value and experience a sharp correction in subsequent periods as prices adjust to reflect fundamentals.”

 Related: ESG Momentum Tilt Shows Outperformance & Why Too Much Research Produces False Factors