Factor Demand and Factor Returns

Abstract

We propose a novel source of predictable price pressure resulting from mutual funds’ factor rebalancing behavior. When a fund’s factor demand is persistent, it needs to rebalance the portfolio’s factor exposure, leading to predictable trading at the stock level. This form of predictable trading operates independently from trading induced by retail flows and has distinct implications for cross-sectional return predictability. Consistent with demand-induced price pressure, stocks whose characteristics are well-matched with the underlying funds’ factor demand experience more buying pressure and higher returns, whereas mismatched stocks experience more selling and lower returns. We calculate the scale of factor rebalancing and estimate an average factor demand elasticity of -0.23.

Presentation

RCFS/RAPS Conference at Baha Mar 2019, CICF 2019, SGF 2019, AFA 2021, MFA 2021, NFA 2021, Finance Down Under 2022, SFS Cavalcade North America 2022, FIRS 2022, 10th Helsinki Finance Summit; Birkbeck (University of London), BlackRock, Cambridge, LSE, Notre Dame, Peking University, USI Lugano, Yale SOM

Award

CFAM-ARX Paper Award, Finance Down Under Conference, 2022

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