Crowded Trades and Tail Risk

Abstract

A growing body of research examines the implications of common holdings for asset price determination; however, far less is known about the impact of hedge fund ownership concentration on risk and return. Yet, hedge fund positions are an important component of the degree of crowdedness because these investment vehicles tend to be particularly active in their pursuit of outperformance, they often take highly concentrated positions, and they utilize leverage and short sales. Using a large database of U.S. equity position-level holdings for hedge funds, we measure the degree of securitylevel crowdedness. We construct a new factor by taking the difference between returns of high and low crowdedness portfolios. The average return on the crowdedness factor is sizable, and its variation is distinct from other traditional risk factors for U.S. equities. When hedge fund returns are regressed onto other risk factors and the crowdedness factor, the exposures to the latter are statistically and economically significant in explaining hedge fund return variation. Most important, the crowdedness factor is related to downside “tail risk” as stocks with higher exposure to crowdedness experience relatively larger drawdowns during periods of market distress. This tail risk extends to hedge fund portfolio returns as the crowdedness factor explains why some funds experience relatively large drawdowns.

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