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

Abstract

We model financial innovations such as Exchange-Traded Funds, smart beta products, and many index-based vehicles as composite securities that facilitate trading common factors in assets' liquidation values. Through accessing a larger basket of assets in endogenously-chosen proportions, composite securities can benefit both informed and liquidity traders and attract all factor investors with optimal designs that feature selecting liquid and representative assets. Consistent with empirical findings, introducing composite securities leads 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. Trading transparency, distinction between bundles and derivatives, and endogenous information acquisition also significantly affect prices and security design.