Rise of Factor Investing: Asset Prices, Informational Efficiency, and Security Design

Finance

Further details

We model financial innovations such as Exchange-Traded Funds (ETFs), smart beta products, and many index-based vehicles as composite securities that facilitate trading large baskets of assets with a common factor in liquidation values. Equilibria exist in which factor investors, regardless of their informedness and liquidity needs, all prefer trading composite securities and prefer the same designs involving liquid and representative assets. Consistent with empirical findings, composite securities lead to higher price variability and co-movements, larger trading costs and synchronicity, and lower asset-specific but higher factor information in prices, especially for illiquid assets. Transparency of composite security trading, distinction between composite bundles and derivatives, and endogenous information acquisition also significantly affect prices and security design.