Crowding and Liquidity Shocks

Abstract

The authors develop a model whose aim is to study the relationship between crowding and liquidity shocks. One of the main results of that model is that crowding is associated with a larger exposure to broader liquidity shocks on arbitrageurs. The authors confirm this link empirically by studying equity long–short strategies. They use short interest data both to identify liquidity shocks impacting sophisticated equity investors and to infer crowdedness for some of the well-known long–short equity factors. When liquidity shocks (such as the 2007 quant crisis or the more recent 2020 COVID-19–induced quant deleverage) occur, crowded strategies indeed tend to underperform.