The Rise of Factor Investing: "Passive" Security Design and Market Implications

Lin Cong, Shiyang Huang and Douglas Xu

No 32016, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: We model financial innovations such as Exchange-Traded Funds, smart beta products, and many index-based vehicles as composite securities (CSs) that facilitate trading the common factors in assets' liquidation values. Through accessing a larger basket of assets in endogenously chosen proportions, CSs reduce investors' duplication of effort in trading multiple securities and attract more factor investors. We characterize analytically how competitive CS designers in equilibrium optimally select liquid underlying assets representative of the factors and find corroborating evidence in ETF data. CS trading entails investors' strategic and active decisions, consequently impounding more systematic information into prices. Their rise creates leads to greater informational efficiency, price variability, and co-movements in the underlying asset markets, as well as potentially heterogeneous effects on liquidity and asset-specific information acquisition/incorporation, depending on the importance of factors for asset value. The predictions explain and reconcile the rich (and often mixed) empirical observations about various types of CSs in the extant literature.

JEL-codes: D40 D82 G11 G14 G23 (search for similar items in EconPapers)
Date: 2024-01
New Economics Papers: this item is included in nep-ban, nep-des, nep-fmk, nep-ifn and nep-mst
Note: AP CF
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