Questioning the Wisdom of Crowds to Design Portfolio Diversification Strategies.

For many years, bonds have provided investors in a traditional 60/40 asset mix with 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 novel tool involves creating a long-short portfolio of uncrowded assets. In particular, crowding in stocks held by asset managers has a significant impact on stock performance. Crowded assets and strategies result in outperformance during trending markets but exhibit significant drawdowns and failures of diversification during spikes in volatility. Crowded stocks are expected to deliver negatively skewed market-adjusted returns and higher forward volatility once the market players give up on crowded trades. Conversely, uncrowded assets have the potential for positive skewness and long vol-like behavior. This article computes a stock-level crowding measure based on active bets by mutual and hedge funds. We construct a long-short equity portfolio based on a combination of a pure holdings-based crowding measure that is long volatility, has minimal equity beta, is not persistently correlated with common risk factors (style), and has a negative correlation to the most crowded stocks. We show how this long-short equity portfolio can be combined with a traditional 60/40 portfolio in order to provide better structural diversification. [ABSTRACT FROM AUTHOR]