Abstract
Although hidden, the implicit market impact costs of factor investing may substantially erode a strategy’s expected excess returns. The rebalancing data of a suite of large and long-standing factor-investing indexes are used in this study to model these market impact costs. A framework to assess the costs of rebalancing activities is introduced. These costs are then attributed to characteristics that intuitively describe the strategies’ demands on liquidity, such as rate of turnover and the concentration of turnover. A number of popular factor-investing implementations are identified, and the authors discuss how their index construction methods, when thoughtfully designed, can reduce market impact costs.
Highlights
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We focus on unmasking the market impact costs that arise from synchronous buying and selling
Because we set out to study the cost of investment strategies implemented by managers whose mandate is to track indexes as closely as possible, we focused on the immediate market impact and assumed no strategic scheduling of trades beyond those occasioned by index rebalancing
Summary
Our market impact model potentially overestimates the cost of large changes in positions because we assumed all portfolio managers rebalance a given indexing strategy on the same trade day. Our model undoubtedly misestimates the cost of large trades that the market anticipates, such as S&P 500 reconstitutions. In these cases, arbitrageurs may step up to provide liquidity around the trade day (see, e.g., Petajisto 2011). Sophisticated managers may turn to off-exchange facilities, such as crossing networks or dark pools. For these reasons, we provide our framework, results, and discussion merely to illuminate the less obvious challenges involved in designing and selecting factor-investing strategies. We contend that the model captures salient factors, but we do not claim it definitively quantifies or accurately predicts actual market impact costs
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