No evidence exists to support the theory that smart beta strategies have been adversely affected by a crowding effect, a new paper has revealed.
The research entitled Crowding Risk in Smart Beta Strategies, published by Scientific Beta, said that as smart beta strategies gain in popularity, there have been concerns that flows into these strategies will ultimately cancel out their benefits. However, co-author of the paper Noël Amenc said “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.
“In addition, not only our work, but also work from other researchers shows that factor premia do not disappear when the research that justifies the premia is published.”
Periodic underperformance may be due to normal fluctuations in prices, the paper stated, and the best precaution against crowding is diversification.