Crowding and Tail Risk in Momentum Returns

Several theoretical studies suggest that coordination problems can cause arbitrageur crowding to push asset prices beyond fundamental value as investors feedback trade on each others’ demands. Using this logic, we develop a crowding model for momentum returns that predicts tail risk when arbitrageur...

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Bibliographic Details
Published in:Journal of financial and quantitative analysis 2022-06, Vol.57 (4), p.1313-1342
Main Authors: Barroso, Pedro, Edelen, Roger M., Karehnke, Paul
Format: Article
Language:English
Subjects:
Coordination
Crowding
Feedback
Feedback control systems
Premiums
Prices
Risk assessment
Risk factors
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Summary:Several theoretical studies suggest that coordination problems can cause arbitrageur crowding to push asset prices beyond fundamental value as investors feedback trade on each others’ demands. Using this logic, we develop a crowding model for momentum returns that predicts tail risk when arbitrageurs ignore feedback effects. However, crowding does not generate tail risk when arbitrageurs rationally condition on feedback. Consistent with rational demands, our empirical analysis generally finds a negative relation between crowding proxies constructed from institutional holdings and expected crash risk. Thus our analysis casts both theoretical and empirical doubt on crowding as a stand-alone source of tail risk.
ISSN:0022-1090
1756-6916
DOI:10.1017/S0022109021000624