Crowding Risk in Smart Beta Strategies

A Scientific Beta Publication
Crowding Risk in
Smart Beta Strategies
April 2020
A Scientific Beta Publication — Crowding Risk in Smart Beta Strategies — April 2020
2 Copyright © 2020 Scientific Beta. All rights reserved. Please refer to the disclaimer at the end of this document.
Table of Contents
Introduction................................................................................................................................................................... 5
Crowding Risk and Economic Explanations of Factor Premia........................................................................ 7
Macroeconomic Conditions Contribute to Factors’ Short-Term Variations .............................................11
Where is the Evidence?.............................................................................................................................................14
Conclusion - A Practical Answer to Crowding Concerns................................................................................19
References....................................................................................................................................................................22
About Scientific Beta.................................................................................................................................................25
Scientific Beta Publications.....................................................................................................................................27
Printed in France, April 2020. Copyright © 2020 Scientific Beta. All rights reserved. Please refer to the disclaimer at the end of this document.
The authors can be contacted at contact@scientificbeta.com.
Copyright © 2020 Scientific Beta. All rights reserved. Please refer to the disclaimer at the end of this document. 3
Abstract
There are concerns that, as Smart Beta strategies gain popularity, flows into these strategies will
ultimately cancel out their benefits. However, such claims are rarely based on solid empirical
evidence. The academic literature has not only documented risk premia for the standard
factors but has also provided theoretical explanations for persistence, notably if factors are
compensation for taking on additional types of risk. Moreover, precautions against crowding risks
can be taken by proper implementation of factor investing and Smart Beta indices. In particular,
the best precaution against crowding seems to be diversification.
Of course, it is possible that Smart Beta and factor strategies can be subject to adverse effects
due to a wide following but one can only conclude that this is the case if there is evidence for it.
Losses in a given strategy, meanwhile, are not evidence of crowding. Periodic underperformance
may be due to normal fluctuations in prices. In fact, claiming that there must be crowding in a
factor because it suffers from losses completely ignores the nature of risk premia. A risk premium
corresponds to a higher average return that is the compensation for taking on additional risk.
Therefore, losses to any factor strategy over any particular period do not imply that the long-
term premium has disappeared because of “crowding”. Such losses may simply suggest that the
reward for holding the factor comes with associated risk. Indeed, evidences from the academic
literature show that the risk premia of these strategies have not disappeared after publication.
Moreover, the effect of increased investments on price-impact costs can be significantly
reduced by adopting proper investability rules.
The confusion about factor crowding can have negative consequences for investors, leading
them to invest in novel exotic factors which, in the end, are not rewarded and expose them to
heightened data-mining risks. In fact, exotic new factors are typically justified on the basis of
short-term data and use proprietary complex scoring approaches to claim that such factors are less
replicable and therefore less prone to crowding. A necessary consequence is that these factors are
often over-fitted and will not be robust out of sample.
About the Authors
Noël Amenc, PhD, is Professor of Finance and Associate Dean for Business
Development at EDHEC Business School and the founding Chief Executive Officer
of Scientific Beta. His concern for bridging the gap between university and
industry has led him to pursue a double career in academe and business. Prior
to joining EDHEC Business School as founding director of EDHEC-Risk Institute,
he was the Director of Research of Misys Asset Management Systems, having
previously created and developed a portfolio management software company.
He has published numerous articles in finance journals as well as four books on
quantitative equity management, portfolio management, performance analysis,
and alternative investments. He is a member of the editorial board of the Journal of
Portfolio Management, associate editor of the Journal of Alternative Investments,
and member of the advisory board of the Journal of Index Investing. He is also a
member of the Finance Research Council of the Monetary Authority of Singapore.
He was formerly a member of the Consultative Working Group of the European
Securities and Markets Authority (ESMA) Financial Innovation Standing Committee
and of the Scientific Advisory Council of the AMF (French financial regulatory
authority). He holds graduate degrees in economics, finance and management
and a PhD in finance.
Giovanni Bruno is a Senior Quantitative Analyst at Scientific Beta and a member

of the EDHEC Scientific Beta research chair. His research focuses on asset pricing.
He earned his PhD in finance at the Norwegian School of Economics, where he
also worked as a Teaching Assistant delivering courses on Investments, Derivatives
and Risk Management and Quantitative Investment. He holds a Master’s Degree
from LUISS Guido Carli University (Italy), where he obtained First-Class Honours
in Quantitative Finance. Previously to his PhD, he held roles as a Consultant and a
Quantitative Analyst with PricewaterhouseCoopers and Altran, respectively, where
he specialised in Financial Risk Management.
Felix Goltz is Research Director, Scientific Beta and also a member of the EDHEC
Scientific Beta research chair. He carries out research in empirical finance and asset
allocation, with a focus on alternative investments and indexing strategies. His
work has appeared in various international academic and practitioner journals
and handbooks. He obtained a PhD in finance from the University of Nice Sophia-
Antipolis after studying economics and business administration at the University
of Bayreuth and EDHEC Business School.
5
Introduction
Introduction
A recurring criticism of Smart Beta strategies is the presumption of a risk of “crowding”. It is frequently
pointed to as a potential risk but is rarely formalised or even defined. Without a definition, it is
impossible to draw relevant conclusions. If it is not clear how crowding is defined or how it can be
measured, it is futile to talk about it.
The main idea behind a crowding risk is that, as more people discover how successful Smart Beta
strategies are and increasingly invest in them, flows into these strategies will ultimately cancel out
their benefits. If an increasing amount of money starts chasing the returns of a momentum strategy,
for example, it is possible that the reward for holding this strategy – which has been documented
with historical data – will ultimately disappear.
Given that the most popular Smart Beta strategies already have a wide following, it should be
possible to establish evidence of the negative effects, if they exist, of being followed by increasing
numbers of investors. One should be able to determine whether popular Smart Beta indices have led
to over-crowding and come up with an empirical estimate of the magnitude of the drag associated
with crowding that has occurred so far. As of today and to the best of our knowledge, there is no
such evidence. This does not mean that such evidence may not be produced in the future, of course.
However, it is important to ask what current claims about crowding are founded upon and the answer
is often that we are in the realm of unfounded assertions.
Moreover, even when looking at the reasoning behind the supposed risk of crowding, one discovers
several issues with the common wisdom.
Below, we first address the insights one can gain from considering the economic rationale behind
factor premia. We then turn to reviewing the empirical evidence on crowding and finally discussing
practical considerations.
7
Crowding Risk and Economic Explanations

of Factor Premia

of Factor Premia
Whether or not we should expect crowding in Smart Beta strategies is closely related to the economic
explanations of the premia that we observe in the data. If factor premia are explained by a rational
risk premium, they are likely to persist because some investors will rationally avoid a tilt despite
the higher returns. Some investors may rationally choose to accept the lower returns of stocks
that have good payoffs in bad times where marginal utility of consumption is high, and may thus
hold portfolios that go against rewarded factor tilts (e.g. by focusing on large cap growth stocks).
If on the contrary, factor premia are due to systematic errors, and investors learn over time to correct
these errors, factor strategies may indeed see diminishing premia, except if there are limits to the
arbitrage which mean that many investors will not be able to benefit from the premium.
This issue has been discussed extensively, for example in Cochrane (1999). Proponents of the
crowding argument claim that it will occur in standard factors and that factor premia will indeed
diminish, but this is not to be expected if factors are explained rationally. Risk-based explanations
provide reasons for why factor premia should persist – even if investors are widely aware of them.
Some investors will shy away from exploiting the premium even if they are convinced of its existence,
either because they are not willing to take on the associated risks or because they are prevented
from going against biased behaviour because of institutional constraints.
Some who theorise about the existence of crowding argue that the losses occurring in a particular
factor at some point in time provide evidence. For example, Yasenchak and Whitman (2015)
argue that “given the increase in popularity of smart-beta strategies, there is a similarly increased
overcrowding risk, which could result in factor crashes”.
Given such claims, one can ask whether the losses in a particular factor at a particular point in time
are indeed evidence of crowding. However, if a loss in a factor is proof of “crowding” one might
as well claim that equity market crashes are a signal of overcrowding in the cap-weighted equity
index. And when long-term bonds severely underperform short-term bonds over a short period,
is this then evidence of crowding by investors who are chasing the term premium? How can we
conclude that such fluctuations are due to “crowding” rather than normal price fluctuations for risky
assets that are completely “uncrowded”? Again, in the absence of a definition of crowding, it is not
clear what one can conclude. If the argument is simply that returns vary over time and at times
may be low, then it is not clear how factors are any different from the equity market, for example.
The fact that returns vary over time does not mean that, in practice, investors are better off by
accounting for such time variation through “timing” decisions rather than being exposed to the
long-term premium (see Asness, 2016).
In fact, claiming that there must be crowding in a factor because it suffers from losses completely
ignores the nature of risk premia. A risk premium corresponds to a higher average return that is due
to taking on additional risk. All risk factors will have returns which vary substantially over time, and
only an analysis of long-term data can lead to any meaningful conclusions on the average premium.
We should note with Black (1993) that “we need decades of data for accurate estimates of average
A Scientific Beta Publication — Crowding Risk in Smart Beta Strategies — April 2020 9
Copyright © 2020 Scientific Beta. All rights reserved. Please refer to the disclaimer at the end of this document.

of Factor Premia
expected return. We need such a long period to estimate the average that we have little hope of
seeing changes in expected returns.” An example of the difficulties in concluding on changes of factor
premia is the small cap effect.
There is a growing belief that the size effect has disappeared and this has been widely published.
This is however mainly based on empirical results over the period 1980 to 2000 and thus
sample-specific.
For example, Hirshleifer (2001) states: “The U.S. small firm effect has been weak or absent in the last
15 years.” Horowitz, Loughran and Savin (2000) show that the return to the size factor was negative
between 1980-96 and suggest that the effect has disappeared.
However, such claims are often based on short-term analysis, which is inappropriate to conclude
on the existence of a factor premium. To illustrate that conclusions on disappearance of the small
cap premium can be sample specific, below we show the size premium (annualised return) and its
associated t-statistic over rolling periods of 15 years.
Exhibit 1: Rolling 15-year average annualised return premium of the size factor in the US (1926 - 2019)
US size factor (SMB) returns are obtained from Kenneth R. French’s data library http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.
html. The analysis is based on daily returns from 01/07/1926 to 31/12/2019. Starting from 1926, 15-year average annual returns are calculated by
rolling each year forward until 2019 and the corresponding t-statistics are calculated.
The results in Exhibit 1 suggest that, at times, one will tend to conclude that the premium has
disappeared when looking at such time periods of 15 years. In particular around the turn of the
millennium, it was popular to state that the premium likely disappeared after it became widely
known following its publication by Banz in 1981. Exhibit 1 shows indeed that the returns of the
size factor were clearly negative during the late 1990s. However, the size factor then showed
strong positive returns up to the year 2013. Conclusions on its disappearance may thus have been
premature. It is also worth noting that there had been earlier occurrences of such negative returns.
For example 15-year returns during the early 1960s showed similar losses from the size factor.

of Factor Premia
Of course, these losses came before the publication of the size effect. We would therefore challenge
the idea that they were due to crowding.
Perhaps such results merely suggest that returns from factors vary over time and we need very
long time spans of data to conclude on the significance of a premium. Given the variation in
premia, it is difficult to conclude reliably that a factor has truly disappeared even over relatively
long time spans. A fortiori, claiming that factor premia have disappeared due to crowding based on
short-term performance is a risky business as far as the reliability of such conclusions is
concerned.
Indeed, due to fluctuations in average returns, it likely that we will observe periods with low returns,
and given the uncertainty in estimating returns reliably, any sample-specific conclusions should be
handled with care. As an example, it is noteworthy that while it is frequently asserted that the size
factor has disappeared, Fama and French (2015c) show that it is empirically important over the long
term, whether it is for the period 1927-1963 or 1963-2013.
Similarly, the value factor has been argued to be redundant based on sample-specific analysis. For
example, Fama and French (2015a) concluded based on a US sample that the value factor is redundant.
But Fama and French (2015b) do not find evidence of the redundancy of the value factor in global
data and caution that their earlier results on redundancy may be sample-specific.
Moreover, comprehensive comparisons of multi-factor models including different sets of factors

show that factors such as value and size need to be included to successfully explain the cross-section
of expected returns (see Barillas and Shanken, 2015).
In a nutshell, focusing on specific time periods is poorly suited to drawing inferences on the
long-term behaviour of factors. In fact, losses in any factor strategy over a particular period do
not necessarily suggest that the long-term premium has disappeared because of “crowding” into
a fashionable factor. Such losses may simply suggest that the reward for holding the factor comes
with associated risks.
11
Macroeconomic Conditions Contribute to

Factors’ Short-Term Variations
Macroeconomic Conditions Contribute

to Factors’ Short-Term Variations
One of the rational explanations of the factor risk premia is the relationship between factor
returns and the business cycle. Investors should care about how factors behave under different
macroeconomic conditions because these will affect their marginal utility. This intuition has been
formalised in numerous theoretical models. For instance, the Merton (1973) intertemporal CAPM is
a rational model that predicts how exposures to variables that forecast future economic conditions
should be priced.
The link between factors’ expected returns and news related to macroeconomic conditions is
well documented in the financial literature. Hahn and Lee (2006) find that the term spread and
default spread contribute to explaining variations in the returns of the size and value factors.
Petkova (2006), Petkova and Zhang (2005), and Hameed, Kang and Viswanathan (2010) suggest
that the size and value factors are exposed to the term spread, default spread, short rate and
aggregate yield. Baker and Wurgler (2012) show that the low risk factor is related to interest rate
factors, while Cederburg and O’Doherty (2016) find a dependence with term spread, dividend
yield, default spread and short rates. There is also some evidence regarding the link between
macroeconomic shocks and Momentum. Liu and Zhang (2008) show that past winners have
higher expected growth than losers, especially when the expected economic activity is high.
Boons (2016) shows that macro state variables that are related to future economic activity are priced
in the cross section of stock returns.
In a recent paper (Amenc et al., 2019), Scientific Beta’s researchers build on these empirical
findings to select candidate macro variables and assesses the corresponding sensitivities across six
consensus equity factors. They select seven macroeconomic variables1 that are well established
in the financial literature for their ability to characterise the business cycle. They then show that
the equity factors have substantial exposure to macroeconomics risk, which may lead to factors’
underperformance in the short-term.
Exhibit 2 shows the return differences between times with positive and negative macroeconomic
surprises for each of the seven given macroeconomic variables. The table shows that factors
indeed come with significant macroeconomic risks. Factor returns differ significantly across states, as
defined by innovations in the seven macroeconomic variables. Indeed, none of the factors is neutral
with respect to all of the variables. The macro spreads are not only statistically significant but also
important economically, in terms of magnitude.
For example, the return spread of the low investment factor and the value factor across states with
different interest rate conditions (either in terms of short rate or term spread innovations) exceeds
7% annualised in absolute terms. This spread is about twice as large as the unconditional average
return, 3.2% and 3.7% respectively for these two factors. Thus, an investor looking to harvest the
unconditional value or low investment factor premium is exposed to strong deviations in outcome
depending on macroeconomic conditions.
1 - The short term rate, the term spread, the default spread, the dividend yield, the bid-ask spread, the price impact and the systematic volatility (more
details can be found in Amenc et al. 2019).
Macroeconomic Conditions Contribute

to Factors’ Short-Term Variations
Exhibit 2: Sensitivity of premia to surprises in macroeconomic state variables

The first panel of the table reports unconditional annualised geometric mean returns of six equity risk factors. The second panel reports macro spreads,
defined as the difference between the annualised geometric mean returns of equity factors when innovations in state variables were in the highest
and lowest quartiles. Innovations come from VAR(1) model, and are orthogonalised to the market excess returns. Significance based on Welch’s t-test
at the 10%, 5% and 1% levels is indicated by *, ** and ***, respectively. The results are based on monthly data from July 1963 to December 2017.
Size Value Mom Low Risk High Prof Low Inv
Unconditional Performance
Annualised Return 2.5%** 3.7%*** 7.0%*** 9.3%*** 2.7%*** 3.2%***
Macro Spreads
Short rate 3.8% -8.4%* 1.4% -10.5%** -0.6% -7.8%***
Term spread 1.2% 9.2%** -13.5%** 5.4% -5.6%* 7.8%***
Default spread -5.3% -0.1% -2.0% 2.5% 6.8%** -1.8%
Dividend yield 4.3% -5.9% -6.1% -18.5%*** -14.8%*** -3.5%
Effective spread 11.1%** 0.1% 6.7% 4.5% 2.5% -0.8%
Price impact -3.0% -0.3% 4.8% 0.1% -1.9% -2.6%
Systematic volatility -9.9%** -6.8% -4.9% -16.2%*** 1.8% -4.6%
Data source: CRSP, K. French data library, AQR dataset, FED of St. Louis. (This table is from Amenc et al. 2019)
These results show us that short-term periods of factor underperformance are significantly
linked to variations in the macroeconomic environment. Temporary negative performance of these
factors is to be expected and is not a proof of the existence of “crowding” effects.
14
Where is the Evidence?

While there is no specific evidence on the crowding effects in particular Smart Beta indices, a small
number of recent studies examine potential effects of wide use of common factors for which a reward
has been broadly documented.
While proponents sometimes cite such studies to substantiate their claims about crowding risk,
it should be emphasised that recent studies do not provide clear evidence to suggest that factor
premia are likely to disappear because of crowding.
Does Crowding Increase Smart Beta’s Cost of Replication?

When inspecting the results in the unpublished working paper of Yost-Bremm (2014), which is
sometimes cited in support of the crowding theory, one does not find conclusive evidence that
crowding effects impose any meaningful cost on factor investors. Even though the paper finds
evidence of abnormal trading volume for stocks which switch across thresholds of standard factor
portfolios, the results do not imply that there is a heavy burden for strategies following standard
factors. In fact, the evidence presented is strong for effects on trading volume but much weaker for
effects on stock returns.
If one considers for example the effects around stocks that switch into the value portfolio, the results
suggest the following:
The study reports an effect on trading volume, which is significant and consistent. Volume in
switching stocks tends to increase consistently and in a statistically significant manner across the
different model specifications the author tests. However, the return effect is not very consistent. Thus,
while the volume effects are consistently shown as positive and significant for stocks switching to
the value portfolio, return effects are often insignificantly different from zero across the different
model specifications, which is hardly strong evidence of an abnormal return phenomenon. Moreover,
results in the paper show that a small percentage of firms actually switch into the value portfolio
so that any abnormal returns of switching stocks only apply to a small fraction of assets held.
The overall effect on a value portfolio investor would be muted by the fact that most of the assets
held are not switching stocks.
Proponents of crowding believe that it eliminates the benefits of Smart Beta strategies by
increasing implementation costs. They believe that Smart Beta strategies have severely limited
capacity, meaning that, as the assets under management (AUM) grow, the price-impact cost
generated at rebalancing will quickly erode their profits (see Blitz and Marchesini, 2019). Therefore,
to understand to what extent the effect of crowding on implementation costs is a concern, it is
necessary to understand under what conditions a price impact may emerge.
Price impact is a feature of real life trading where investors operate on markets with frictions.
Indeed, while in rational and frictionless markets assumed in many theoretical models the price
of every financial asset is uniquely determined by its discounted cash-flows, in the presence of
frictions liquidity providers will require a compensation to absorb large trades. This compensation
will translate into a price impact, meaning a higher price for buyers and a lower price for sellers.
Therefore, liquidity is the crucial determinant of the capacity of these strategies.
Indeed, although, the estimates of price impact and capacity of factor strategies are various and
dissimilar, a common finding is that the application of proper investability rules contributes to
reducing the costs of replication and to increasing capacity. For instance, using proprietary datasets,
both Ratcliff, Miranda and Ang (2017) and Frazzini, Israel and Moskowitz (2015), estimate the price
impact of factor strategies from trades that are implemented adopting techniques to optimise
investability. Based on those estimates, both studies conclude that capacity of these strategies is
quite large. By contrast, Novy-Marx and Velikov (2016) find that the capacity of some academic
factor strategies, meaning strategies that do not employ any cost-mitigating technique,
is quite low.
However, when they employ simple cost-mitigating methods, the estimates of capacity significantly
improve, a finding that is confirmed also in Novy-Marx and Velikov (2019), in which they test the
efficacy of different investability rules. Furthermore, as shown in DeMiguel et al. (2019), the effect
of crowding on price-impact costs is alleviated by trade diversification. Because trades of different
strategies are not perfectly correlated, the combination of different strategies decreases turnover
and price-impact costs2.
Therefore, the effect of crowding on price-impact costs cannot be generalised to all Smart Beta
strategies. Instead, it crucially depends on the way the strategies are implemented. Recent empirical
findings show that properly implemented Smart Beta strategies have not suffered because of price
impact. For instance, Bregnard, Bruno and Goltz (2019) estimated the price impact generated by
the rebalancing of two multi-factor Smart Beta indices, and measured their performance drag, the
negative effect of price impact on index performance. Note that, being multi-factor, these indices can
exploit the benefits of trade-diversification. Moreover, they improve liquidity by applying stringent
investability rules3. As a result, Bregnard, Bruno, and Goltz (2019) found no evidence of significant
price effects, as show in Exhibit 34 for the indices they study. Indeed, that the performance drag is
close to zero and even negative suggests that performance of the two Smart Beta indices is not hurt
by price effects during their rebalancing events.
Exhibit 3: Performance drag

The table reports the annualised average performance drag (PD) from December 2013 to March 2018 (live period) of the US Multi-Beta Multi-Strategy
4-Factors EW and the Dev. ex- US Multi-Beta Multi-Strategy 4 Factor EW. We report the PD obtained using the CAR estimated with the characteristics
based methodology of Daniel et al. (1997) for two event windows AD:ED and ED. The demand pressure used for selecting the stocks is Weight changes.
This table is taken from Bregnard, Bruno and Goltz (2019).
Event Date US MBMS 4-Factors EW Dev. Ex-US MBMS 4-Factors EW
AD:ED -0.02% -0.07%
ED 0.00% -0.01%
2 - This paper is closely related to Bonelli et al. (2019) showing that another determinant of the effect of crowding on price-impact cost is the persistence
of the signal used to implement the strategy (e.g. Book to Market, Market Capitalisation, Asset Growth etc.).
3 - The investability rules of these indices are described in details in Amenc, Bruno and Goltz (2019).
4 - Note that the performance drag from any price effects would also be included in index performance, as long as it consists of a live track record during
times when actual investments replicating the index took place.
Do Factors’ Risk Premia Disappear After Publication?

McLean and Pontiff (2016) address the question of whether the publication of results showing a return
premium associated with an equity factor destroys this premium going forward. Specifically, they
analyse the returns of almost 100 different strategies that tilt towards single or composite variables,
such as accounting variables or return-based variables. It should be noted that the study includes
both consensus factors, such as those listed in the table above, and less standard factors. Such
non-standard factors are based on variables such as the firm age, corporate governance measures,
inventory-related measures, seasonality, revenue surprises, changes in R&D spending, and analyst
earnings forecasts5. The authors analyse the in-sample result for a return premium over the period
used in the original study. They contrast this premium with the premium observed out of sample
but before publication, and with the post-publication premium up to today.
If investors automatically “crowd” into factors once they know about the documented reward, one
would expect the premia to decline after publication of the respective paper. McLean and Pontiff
(2016) attribute a 32% drop in returns to the publication effect. However, the authors also reject
the hypothesis that post-publication anomaly returns decay entirely. The key conclusion is thus
that while the publication of academic research tends to lower returns going forward, these premia
do not disappear. It is noteworthy that this result is obtained when analysing a large number of
almost 100 factors, which include not only standard factors. As one increases the number of factors
it may indeed be plausible that this may include ad-hoc factors with no clear economic rationale.
Persistence of premia may arguably be even stronger when constraining the analysis to factors with
a strong risk-based explanation. That the authors reject the hypothesis of disappearing rewards even
for an extensive set of factors which may include strategies that do not have a strong risk-based
rationale is indeed strong evidence against the theory that crowding automatically cancels out factor
returns for any systematic Smart Beta strategies.
More recently, Jacobs and Müller (2020) have extended the analysis of post publication returns to
international data. They confirm the findings of McLean and Pontiff for US equities, that there is
some reduction in factor premia, but this reduction does not eliminate the premia. For international
markets outside the US, they do not find any evidence that premia have reduced at all following
publication. Overall, the evidence thus suggests that, once known, factor premia stay intact.
Building on the extensive evidence in the literature that publication does not destroy factor
premia, we provide a simple illustration using the six most consensus factors. We construct a
multi-factor portfolio that allocates equal weights each year only to factors (long-short portfolios)
that had been published at that time. Starting with only one factor in 1972, the strategy adds an
additional factor once it gets published. From 2004 onwards, all six factors have been published
and are thus included in the strategy. Exhibit 4 shows that the return of such a strategy would
have been positive (the annualised return is 5.44%) and strongly statistically significant (the
t-statistic is 5.53). Note that the strategy never includes factors that have not been published.
The returns therefore are based only on factors that were known when the strategy invested in them.
5 - These variables are listed in the internet appendix to McLean and Pontiff (2016), see Table I.A.III
Both the extensive empirical evidence and this simple illustration suggest that the benefits of factor
investing do not disappear when everybody knows about factors.
Exhibit 4: Post-Publication Performance

The graph reports the cumulative monthly returns of a portfolio rebalanced at the end of each year that equal-weights across all the factors that are
publicly known at that time. Initial portfolio consists of Low Beta factor. The markers on the graph indicate the date when the corresponding factor
was included in the portfolio (next rebalancing date after publication). We use monthly returns from 31-Dec-1972 to 31-Aug-2019 for US stocks. The
data source for BAB (Low Beta) factor monthly returns is AQR, and for other factors is the K. French library. We also report the annualised return of
the portfolio and its t-stat. Under the graph, we report the seminal papers to which we attribute the discovery of the factor.
Factor Low Beta Size Value Momentum Profitability Investment

Seminal Paper Black, Jensen and Banz (1981) Rossenberg, Reid, Jagadeesh, Cohen, Gompers, Titman, Wei, Xie
Scholes (1972) Lanstein (1985) Titman (1993) Vuolteenaho (2004)
(2002)
19
Conclusion - A Practical Answer to

Crowding Concerns
Conclusion - A Practical Answer

to Crowding Concerns
While there is no convincing evidence to prove the crowding theorists correct, thinking about the
economic rationale behind a specific premium should provide ample answers to allay crowding
concerns. If a factor return is explained by a risk-based rationale, there is no reason to expect crowding.
For example, one may theorise that the well-documented long-term outperformance of equity index
funds or long-term bonds over money market funds leads to crowding in the higher return funds.
However, if such extra return is compensation for additional risk (i.e. the equity premium and the term
spread), there is no reason why such premia should disappear even if they are known to investors.
Indeed, the evidence presented in this section and numerous other in the financial literature show
that there is a significant link between factor returns and the business cycle, which is consistent with
the intuition that factor risk premia represents a compensation for exposure to macroeconomic risks.
Therefore, potential Smart Beta investors should conduct thorough due diligence, not only on the
past performance of a given strategy, but also on its economic rationale, and question whether a
given reward can be expected to persist.
Moreover, precautions against crowding risks can be taken by proper implementation of factor
investing and Smart Beta indices. In particular, the best precaution against crowding seems to be
diversification. If investors spread their Smart Beta investments across several strategies, and several
factors, there should not be crowding in a single strategy. Put differently, with so many different
implementations across providers it is hard to imagine how crowding in a particular strategy
would occur. Moreover, if any standalone strategy is well-diversified with weights spread out over
a large number of stocks, such strategies should be less prone to potential crowding. Crowding
concerns thus underline the importance of diversification.
Of course, it is possible that Smart Beta and factor strategies can be subject to adverse effects due
to a wide following but one can only conclude that this is the case if there is evidence for it. Simply
referring to losses in a given strategy however is not an evidence of crowding. Moreover, if one is
concerned about potential crowding, the immediate concern should be to
i) hold well-diversified rather than concentrated strategies, and
ii) spread out over many different strategies.
Such an approach of avoiding concentration and diversifying across strategies is easy to

implement with Smart Beta indices, given the multitude of offerings available, and the different
methodological choices across different indices.
In addition, the concerns over “crowding” issues underline the importance of clarifying investment
beliefs and understanding the rationale for a given factor premium. One can refer to Cochrane
(1999) and Ang, Goetzmann and Schafer (2009) who discuss the practical implications of academic
findings in asset pricing for portfolio management. Such findings suggest that if risk adverse investors
are willing to accept lower returns for holding assets that tend to generate relatively high payoffs
in times when marginal utility is high, they provide supply for other investors who are seeking to
increase returns through exposure to such risk factors.
A Scientific Beta Publication — Crowding In Smart Beta — April 2020 21
Conclusion - A Practical Answer

to Crowding Concerns
The confusion about factor crowding can have negative consequences for investors. Such
confusion may lead investors to invest in novel exotic factors which in the end are not rewarded and
expose investors to heightened data-mining risks. In fact, exotic new factors are typically justified
on short-term data and use proprietary complex scoring approaches to claim that such factors are
less replicable and therefore less prone to crowding but a necessary consequence is that these
factors are often over-fitted and result from model mining and will not be robust out of sample.
In a recent paper, Amenc, Bruno and Goltz (2020) have extensively documented the risk of lack of
robustness associated with over-fitted factors.
Beside these negative consequences, one can only regret that many Smart Beta providers recur to
assertions that are as little conceptually grounded as they are empirically verified.
22
References
References
• Amenc, N., F. Goltz, D. Korovilas, and B. Luyten. 2020. Assessing the Robustness of Smart Beta
Strategies. ERI Scientific Beta Publication (February).
• Amenc, N., G. Bruno and F. Goltz. 2020. Ten Misconception about Smart Beta: Analysing common
claims on performance drivers, investability issues and strategy design choices. ERI Scientific Beta
White Paper (April).
• Amenc, N., G. Bruno and F. Goltz. 2019. Investability of Scientific Beta Indices. ERI Scientific Beta
White Paper (June).
• Amenc, N., M. Esakia, F. Goltz and B. Luyten. 2019. Macroeconomic Risks in Equity Factor Investing.
The Journal of Portfolio Management 45(6): 39-60.
• Ang, A., W. N. Goetzmann and S. M. Schafer. 2009. Evaluation of Active Management of the
Norwegian Government Pension Fund – Global. Research paper (December).
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Issue No.1.
• Baker, M., and J. Wurgler. 2012. Comovement and Predictability Relationships Between Bonds and
the Cross-section of Stocks. Review of Asset Pricing Studies 2(1): 57-87.
• Banz, R.W. 1981. The Relationship between Return and Market Value of Common Stocks. Journal of
Financial Economics 9(1): 3-18.
• Barillas, F. and J. Shanken. 2015. Comparing Asset Pricing Models. Working Paper (No. w21771).
National Bureau of Economic Research. Available at: http://ssrn.com/abstract=2676709 .
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• Black, F., Jensen, M. and Scholes, M. 1972. The Capital Asset Pricing Model: Some Empirical Tests. In:
M. Jensen, ed., Studies in the Theory of Capital Markets, 1st ed. New York: Praeger.
• Blitz, D. and T. Marchesini. 2019. The Capacity of Factor Strategies. Journal of Portfolio Management
45(6) 30-38.
• Bonelli, M., A. Landier, G. Simon and D. Thesmar. 2019. The Capacity of Trading Strategies. Working
Paper.
• Boons, Martijn. 2016. “State variables, macroeconomic activity, and the cross section of individual
stocks.” Journal of Financial Economics 119: 489–511.
• Bregnard, N., G. Bruno and F. Goltz. 2019. Do Factor Indices Suffer from Price Effects around Index
Rebalancing? ERI Scientific Beta White Paper (September).
• Cederburg, S., and M.S. O’Doherty. 2016. “Does It Pay to Bet Against Beta? On the Conditional
Performance of Beta Anomaly.” The Journal of Finance 71 (2): 737-774.
• Cochrane, J.H. 1999. Portfolio Advice for a Multifactor World. Economic Perspectives - Federal
Reserve Bank of Chicago 23(3): pp. 59-78.
• Cohen, R.B., P.A. Gompers, and T. Vuolteenaho. 2002. Who underreacts to cash-flow news? Evidence
from trading between individuals and institutions, Journal of Financial Economics, 66, 409-462.
• DeMiguel V., A. Martin-Utera, F.J. Nogales and R. Uppal. 2019. What Alleviates Crowding in Factor
Investing? Workin Paper. Available at SSRN: https://ssrn.com/abstract=3392875
• Fama, E. F. and K. R. French. 2015a. A Five-Factor Asset Pricing Model. Journal of Financial Economics
116(1): 1-22.
References
• Fama, E. F. and K. R. French. 2015b. International Tests of a five-Factor Asset Pricing Model. Fama-
Miller Working paper, available at: http://ssrn.com/abstract=2622782
• Fama, E. F. and K. R. French. 2015c. Incremental Variables and the Investment Opportunity Set.
Journal of Financial Economics 117(3): 470-488.
• Frazzini, A., R. Israel, and T. J. Moskowitz. 2015. Trading Costs of Asset Pricing Anomalies. Working
paper.
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of Finance 65 (1): 257-293.
• Hirshleifer, D. 2001. Investor Psychology and Asset Pricing. The Journal of Finance 56(4): 1533-1597.
• Horowitz, J.L., T. Loughran, and N.E. Savin. (2000). The Disappearing size Effect. Research in
Economics 54(1): 83-100.
• Jacobs, H. and Müller, S. 2020. Anomalies across the globe: Once public, no longer existent? Journal
of Financial Economics. 135(1): 213-230.
• Jegadeesh, N. and S. Titman. 1993. Returns to Buying Winners and Selling Losers: Implications for
Stock Market Efficiency, Journal of Finance, 48(1), 65-91.
• Liu, L.X.L., and L. Zhang. 2008. “Momentum Profits, Factor Pricing, and Macroeconomic Risk.” Review
of Financial Studies 21 (6): 2417–2448.
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• Novy-Marx, R. and M. Velikov. 2019. Comparing Cost-Mitigation Techniques. Financial Analyst
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• Petkova, R. 2006. “Do the Fama-French Factors Proxy for Innovations in Predictive Variables?” The
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• Petkova, R., and L. Zhang. 2005. “Is value riskier than growth?” Journal of Financial Economics 78:
187-202.
• Ratcliffe, R., P. Miranda and A. Ang. 2017. Capacity of Smart Beta Strategies: A Transaction Cost
Perspective. The Journal of Index Investing 8 (3) 39-50.
• Rosenberg B., K. Reid, and R. Lanstein. 1985. Persuasive evidence of market inefficiency. Journal of
Portfolio Management. Vol 11, 9-17.
• Titman, S., K.C.J. Wei, and F. Xie. 2004. Capital investments and stock returns, Journal of Financial
and Quantitative Analysis, 39, 677-700.
• Yasenchak, R. and P. Whitman. 2015. Understanding the Risks of Smart Beta and the Need for Smart
Alpha. Intech Janus White Paper. Available at: http://ow.ly/WEKQ2.
• Yost-Bremm, C. 2014. Abnormal Trading Around Common Factor Pricing Models. Working Paper.
25
About Scientific Beta

About Scientific Beta
EDHEC-Risk Institute set up Scientific Beta in December 2012 as part of its policy of transferring
know-how to the industry. Scientific Beta is an original initiative which aims to favour the adoption
of the latest advances in “smart beta” design and implementation by the whole investment industry.
Its academic origin provides the foundation for its strategy: offer, in the best economic conditions
possible, the smart beta solutions that are most proven scientifically with full transparency of both
the methods and the associated risks. Smart beta is an approach that deviates from the default
solution for indexing or benchmarking of using market capitalisation as the sole criterion for
weighting and constituent selection.
Scientific Beta considers that new forms of indices represent a major opportunity to put into
practice the results of the considerable research efforts conducted over the last 30 years on portfolio
construction. Although these new benchmarks may constitute better investment references than
poorly-diversified cap-weighted indices, they nevertheless expose investors to new systematic and
specific risk factors related to the portfolio construction model selected.
Consistent with a full control of the risks of investment in smart beta benchmarks, Scientific Beta not
only provides exhaustive information on the construction methods of these new benchmarks but
also enables investors to conduct the most advanced analyses of the risks of the indices in the best
possible economic conditions.
Lastly, within the context of a Smart Beta 2.0 approach, Scientific Beta provides the opportunity
for investors not only to measure the risks of smart beta indices, but also to choose and manage
them. This new aspect in the construction of smart beta indices has led Scientific Beta to build the
most extensive smart beta benchmarks platform available which currently provides access to a wide
range of smart beta indices.
27
Scientific Beta Publications

2020 Publications
• Amenc, N., G. Bruno and F. Goltz. Crowding Risk in Smart Beta Strategies. (April).
• Amenc, N., G. Bruno and F. Goltz. Ten Misconceptions about Smart Beta. (March).
• Amenc, N., G. Bruno and F. Goltz. Investability of Scientific Beta Indices. (March).
• Amenc, N., and F. Ducoulombier. Unsustainable Proposals (February).
• Amenc, N., F. Goltz, and B. Luyten. Intangible Capital and the Value Factor: Has Your Value Definition
Just Expired? (February).
• Amenc, N., F. Goltz, B. Luyten and D. Korovilas. Assessing the Robustness of Smart Beta Strategies.
(February).
• Aguet, D., N. Amenc. Improving Portfolio Diversification with Single Factor Indices. (January).
• Aguet, D., N. Amenc and F. Goltz. Managing Sector Risk in Factor Investing. (January).
• Aguet, D., N. Amenc and F. Goltz. What Really Explains the Poor Performance of Factor Strategies
Over the Last Four years? (January).
2019 Publications
• Amenc, N., and F. Goltz. A Guide to Scientific Beta Multi-Smart Factor Indices. (December).
•  Mathani, R. Effective Frameworks for Forecasting Volatility (December).
• Aguet, D. and M. Sibbe. Scientific Beta Analytics: Examining the Financial Performance and Risks of
Smart Beta Strategies (November).
• Aguet, D. and N. Amenc. How to Reconcile Single Smart Factor Indices with Strong Factor Intensity
(November).
• Aguet, D. and M. Sibbe. Scientific Beta Analytics: Examining the Financial Performance and Risks of
Smart Beta Strategies (November).
• Bruno, G. and F. Goltz . Do we Need Active Management to Tackle Capacity Issues in Factor Investing?
Exposing Flaws in the Analysis of Blitz and Marchesini (2019) (November).
• Bregnard, N., G. Bruno and F. Goltz. Do Factor Indices Suffer from Price Effects around Index
Rebalancing? (September).
• Aguet, D., N. Amenc and F. Goltz. What Really Explains the Poor Performance of Factor Strategies
Over the Last 3 years? (September).
• Ducoulombier, F. and V. Liu. Scientific Beta ESG Option – Upholding Global Norms and Protecting
Multifactor Indices against ESG Risks. (August).
• Amenc, N., P. Bielstein, F. Goltz and M. Sibbe. Adding Value with Factor Indices: Sound Design Choices
and Explicit Risk-Control Options Matter. (July).
• Gautam, K. and E. Shirbini. Scientific Beta Global Universe. (July).
• Aguet, D., N. Amenc and P. Bielstein. Scientific Beta Factor Analytics Services (SB FAS) - A New Tool
to Analyse and Improve your Portfolio. (July).
• Amenc, N., F. Goltz and B. Luyten. Tackling the Market Beta Gap: Taking Market Beta Risk into Account
in Long-Only Multi-Factor Strategies. (July).
• Esakia, M., F. Goltz, B. Luyten and M. Sibbe. Does the Size factor still have its place in multi-factor
portfolios? (July).
Copyright © 2020 Scientific Beta. All rights reserved. Please refer to the disclaimer at the end of this document. 29
• Ducoulombier, F. and V. Liu. Scientific Beta Enhanced ESG Reporting – Supporting Incorporation of
ESG Norms and Climate Change Issues in Investment Management. (July).
• Aguet, D., and N. Amenc. How to reconcile single smart factor indices with strong factor intensity.
(June).
• Aguet, D., N. Amenc and F. Goltz. How to Harvest Factor Premia without Suffering from Market
Volatility: The Case for a Long/Short Multi-Factor Strategy. (June).
• Ducoulombier, F. and V. Liu. Scientific Beta Low Carbon Option – Supporting the Transition to a Low
Carbon Economy and Protecting Multifactor Indices against Transition Risks. (June).
• Shirbini, E. Misconceptions and Mis-selling in Smart Beta: Improving the Risk Conversation in the
Smart Beta Space. (June).
• Amenc, N., M. Esakia, F. Goltz, and B. Luyten. A Framework for Assessing Macroeconomic Risks in
Equity Factors. (May).
• Bruno, G., M. Esakia and F. Goltz. Towards Cost Transparency: Estimating Transaction Costs for Smart
Beta Strategies. (April).
• Amenc, N., P. Bielstein, F. Goltz and M. Sibbe. Adding Value with Factor Indices: Sound Design Choices
and Explicit Risk-Control Options Matter. (March).
• Amenc, N., F. Goltz, and B. Luyten. Assessing the Robustness of Smart Beta Strategies. (March).
• Amenc, N., F. Goltz, M. Esakia and M. Sibbe. Inconsistent Factor Indices: What are the Risks of Index
Changes? (February).
• Aguet, D., N. Amenc and F. Goltz. A More Robust Defensive Offering (February).
• Goltz. F. and B. Luyten. The Risks of Deviating from Academically Validated Factors. (February).
• Scientific Beta Analytics: Examining the Performance and Risks of Smart Beta Strategies. (January).
2018 Publications
• Amenc, N. and F. Goltz. A Guide to Scientific Beta Multi Smart Factor Indices. (December).
• Amenc, N., F. Goltz, A. Lodh and B. Luyten. Measuring Factor Exposure Better to Manage Factor
Allocation Better. (October).
• Amenc, N., P. Bielstein and F. Goltz. Adding Value with Factor Indices: Sound Design Choices and
Explicit Risk-Control Options Matter. (October).
• Aguet, D., N. Amenc, F. Goltz and A. Lodh. How to Harvest Factor Premia without Suffering from
Market Volatility: The Case for a Long/Short Multi-Factor Strategy. (October).
• Aguet, D., N. Amenc, F. Goltz, and A. Lodh. Scientific Beta Multi-Beta Multi-Strategy Solution
Benchmarks. (October).
• Goltz, F. and S. Sivasubramanian. Overview of Diversification Strategy Indices. (June).
• Lodh, A. and S. Sivasubramanian. Scientific Beta Diversified Multi-Strategy Index. (June).
• Ducoulombier, F. and V. Liu. High-Efficiency Carbon Filtering. (May).
• Gautam, K., A. Lodh, and S. Sivasubramanian. Scientific Beta Efficient Maximum Sharpe Ratio Indices. (May).
• Goltz, F. and A. Lodh. Scientific Beta Efficient Minimum Volatility Indices. (May).
• Goltz, F., and S. Sivasubramanian. Scientific Beta Maximum Decorrelation Indices. (May).
• Lodh, A. and S. Sivasubramanian. Scientific Beta Diversified Risk Weighted Indices. (May).
• Sivasubramanian, S. Scientific Beta Maximum Deconcentration Indices. (May).
• Christiansen, E. and F. Ducoulombier. ESG Incorporation – A Review of Scientific Beta’s Philosophy
and Capabilities. (March).
• Christiansen, E. and M. Esakia. The Link between Factor Investing and Carbon Emissions. (February).
• Amenc, N., F. Goltz, A. Lodh and S. Sivasubramanian. Robustness of Smart Beta Strategies. (February).
• Amenc, N. and F. Ducoulombier. Scientific Beta Comments on the Mercer Report “Factor Investing:
From Theory to Practice”. (January).
Disclaimer
The information contained on the Scientific Beta website (the "information") has been prepared by
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Crowding Risk in Smart Beta Strategies

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A Scientific Beta Publication

Crowding Risk and Economic Explanations of Factor Premia........................................................................ 7

Macroeconomic Conditions Contribute to Factors’ Short-Term Variations .............................................11

Where is the Evidence?.............................................................................................................................................14

Conclusion - A Practical Answer to Crowding Concerns................................................................................19

About Scientific Beta.................................................................................................................................................25

Scientific Beta Publications.....................................................................................................................................27

About the Authors

Giovanni Bruno is a Senior Quantitative Analyst at Scientific Beta and a member

Crowding Risk and Economic Explanations

Crowding Risk and Economic Explanations

Crowding Risk and Economic Explanations

Crowding Risk and Economic Explanations

Moreover, comprehensive comparisons of multi-factor models including different sets of factors

Macroeconomic Conditions Contribute to

Macroeconomic Conditions Contribute

Macroeconomic Conditions Contribute

Exhibit 2: Sensitivity of premia to surprises in macroeconomic state variables

Where is the Evidence?

Where is the Evidence?

Does Crowding Increase Smart Beta’s Cost of Replication?

Where is the Evidence?

Exhibit 3: Performance drag

Where is the Evidence?

Do Factors’ Risk Premia Disappear After Publication?

Where is the Evidence?

Exhibit 4: Post-Publication Performance

Factor Low Beta Size Value Momentum Profitability Investment

Conclusion - A Practical Answer to

Conclusion - A Practical Answer

Such an approach of avoiding concentration and diversifying across strategies is easy to

Conclusion - A Practical Answer

About Scientific Beta

About Scientific Beta

Scientific Beta Publications

Scientific Beta Publications

Scientific Beta Publications

Scientific Beta Publications

Scientific Beta HQ & Asia Scientific Beta R&D

Scientific Beta—Europe Scientific Beta—North America Scientific Beta—Japan

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