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

Nov 21, 2024

Working Paper No. 00133-01

security design informational efficiency asset pricing etf passive investing market microstructure indexing

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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. 


Lin William Cong (叢林)

Lin William Cong (叢林)

Cornell University

Douglas Xu

Douglas Xu