Questioning the Wisdom of Crowds to Design Portfolio Diversification Strategies

Key Findings

• For investors in a traditional 60/40 asset mix, bonds for many years have provided a positive carry hedge to equity market volatility and drawdowns. However, with interest rates at historic lows and an evolving inflation backdrop that could impact the negative correlation of stocks and bonds, multi-asset class investors are searching for additional tools to mitigate risk. One such tool involves creating long-short portfolios of uncrowded assets.
• Uncrowded assets tend to outperform crowded assets in periods of stress, as liquidity dries up and investor flows reverse course or flee to cash. This phenomenon leads to positive skewness and positive correlation to the VIX, making a portfolio of uncrowded assets an attractive hedge to equity market drawdowns and addition to a multi-asset class portfolio.
• The initial research develops an approach to building uncrowded portfolios in the equity asset class. It extends insights from past literature in crowding to address both idiosyncratic and common factor crowding in a way that reduces style bias while maintaining the insights of "smart money" investors. Such a long-short equity portfolio has minimal factor biases, avoids the negative carry of other defensive-type assets, and improves the overall Sharpe ratio of a traditional 60/40 asset mix. Future avenues for research involve introducing machine learning tools to predict the behavior of market participants as pertains to crowding and extending the concept of crowding more broadly across asset classes.