Crowded Trades: Implications for Sector Rotation and Factor Timing

Crowded trades are often associated with bubbles. If investors can locate a bubble sufficiently early, they can profit from the run-up in prices. But to profit from a bubble, investors must exit the bubble before the sell-off erodes all of the profits. The authors propose two measures for managing exposure to bubbles. One measure, called asset centrality, locates crowded trading, which they show is often associated with the formation of bubbles. The other is a measure of relative value, which helps to separate crowding that occurs during a bubble’s run-up from crowding that occurs during a bubble’s sell-off. Neither measure by itself is sufficient for identifying the full cycle of a bubble, but the authors show that together these measures have the potential to locate bubbles in sectors and in factors as they begin to emerge and to identify exit points before they fully deflate. TOPICS:Portfolio construction, factors, risk premia, risk management