With few attractive investment opportunities and an increasingly homogenous investor base (long only, real money), the danger of getting caught in a crowded position is both more dangerous and harder to avoid. Because the problem is becoming so much more common, Citi analyst Stephen Antczak, along with Jung Lee and Swati Verma, has worked up what he calls a ‘work in progress’ approach to identifying crowded positions and deciding whether to stay out.

Steps to avoid crowded positions

First step

The first step is to look for unusual flows. Antczak takes the straightforward approach of using a sectors size relative to the market to estimate expected flows. So if the banking sector accounts for 20 percent of the market, it should also get 20 percent of net buys. In fact, banks and auto companies deviated significantly from expected flows in September.

actual v expected buys Crowded position 1013

Second step

The second step is to see whether this unusual flow is a correction. If there were too man net buys this month and too few last month (or whatever timeframe you work with) you may just be looking at noise. But a steady negative trend shows that the position might already be crowded. Looking at banks again, excess net buys aren’t a correction and point to a crowded position.

ongoing excessive bank buying 1013

Third step

Third, you have to decide whether the crowded position will create problems if it unwinds quickly. The auto sector is crowded in the sense that it isn’t perfectly neutral, but the excess buys are so few relative to the size of the industry that this isn’t a good reason to avoid the sector. Banking on the other hand is a heavily crowded sector.

chunky positions banks crowded 1013

Fourth step

But that’s still not necessarily a sign that you should stay out. Once you know that you are looking at a crowded position, you have to decide whether you think it’s vulnerable in the near term. If the percentage of buys/sells change course then you could get in trouble, but until that happens you may still be able to buy in safely.

hyptothetical crowded reversal 1013

“We acknowledge that our approach is a work-in-progress,” writes Antczak. But even if it doesn’t give crystal clear investment advice, at least it gives investors a way to know what they’re getting themselves into.