Crowding and Liquidity Shocks

We study conceptually the relationship between crowding and liquidity shocks. We show that crowding is associated with an exposure to broader liquidity shocks on arbitrageurs. We confirm this link empirically: we use the short interest strategy – buying low short interest stocks and shorting high short interest stocks – as a "barometer" for liquidity shocks impacting sophisticated equity investors. We also show that daily short interest data can be used to infer near real-time crowding indicators for equity long-short strategies and find that sophisticated investors have continued to crowd in some of the well-known 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 under-perform.