Practical Applications of Questioning the Wisdom of Crowds to Design Portfolio Diversification Strategies

In Questioning the Wisdom of Crowds to Design Portfolio Diversification Strategies, from the Winter 2023 issue of The Journal of Alternative Investments, Vadim Zlotnikov, Igor Halperin, Lisa Huang, Cathy Pena (all of Fidelity), and Mikhail Stukalo (of Gainy, a fintech startup), develop a diversification strategy based on measures of crowdedness. They design a portfolio with the positive characteristics of uncrowded stocks that also harvests the skill of active managers. They create a measure of crowdedness using holdings data on active managers. Stocks can become crowded based on conviction, reflecting manager skill. But they also can become crowded due to a consensus view, which leads to problematic characteristics; crowded stocks can exhibit negatively skewed returns with high forward-looking volatility. The authors also construct a long–short portfolio based on two different measures of crowdedness. The portfolio is beta-neutral and can be used to improve the Sharpe ratio of a 60/40 portfolio by dampening volatility. Maintaining smart money investors’ insights, the equity component does not sacrifice returns, as other defensive strategies do.