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Crowding and Tail Risk in Momentum Returns

Published online by Cambridge University Press:  03 September 2021

Pedro Barroso ,
Roger M. Edelen  and
Paul Karehnke Open the ORCID record for Paul Karehnke [Opens in a new window]
Pedro Barroso
Affiliation:
Universidade Católica Portuguesa, Católica-Lisbon School of Business and Economicspedro.barroso@ucp.pt
Roger M. Edelen
Affiliation:
Virginia Tech Pamplin College of Businessedelenr@vt.edu
Paul Karehnke*
Affiliation:
ESCP Business School
*
pkarehnke@escp.eu (corresponding author)
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Abstract

Several theoretical studies suggest that coordination problems can cause arbitrageur crowding to push asset prices beyond fundamental value as investors feedback trade on each others’ demands. Using this logic, we develop a crowding model for momentum returns that predicts tail risk when arbitrageurs ignore feedback effects. However, crowding does not generate tail risk when arbitrageurs rationally condition on feedback. Consistent with rational demands, our empirical analysis generally finds a negative relation between crowding proxies constructed from institutional holdings and expected crash risk. Thus our analysis casts both theoretical and empirical doubt on crowding as a stand-alone source of tail risk.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 57 , Issue 4 , June 2022 , pp. 1313 - 1342
Copyright
© The Author(s), 2021. Published by Cambridge University Press on behalf of the Michael G. Foster School of Business, University of Washington

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Footnotes

We are grateful to Semyon Malamud for comments that were particularly helpful to the article’s development. We are also grateful for helpful comments and suggestions from Jeff Busse, Jennifer Conrad (the editor), John Griffin, Philip Howard (the referee), Hening Liu, Steve Satchell, Rick Sias, Neal Stoughton, Xuemin Yan, and seminar participants at the University of Arizona, California Riverside, New South Wales, Newcastle, Paris-Dauphine, Technology at Sydney, Virginia Tech, EDHEC, INSEAD, Tennessee’s Smokey Mountain Finance Conference, The Annual IDC/Herzliya Conference and Annual Quantitative Trading Symposium, the Financial Risks International Forum, Manchester’s Hedge Fund Conference, the Portuguese Finance Network Conference, Rotterdam’s Professional Asset Management Conference, and the TCU Finance conference. Barroso acknowledges the support from the Portuguese Foundation for Science and Technology (FCT) for the project UIDP/00407/2020. The authors are solely responsible for errors.

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