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

57 Pages Posted: 29 Jun 2016 Last revised: 10 May 2017

Lin William Cong

University of Chicago Booth School of Business

Douglas Xu

University of Chicago; University of Chicago - Booth School of Business

Date Written: November 28, 2016

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.

Keywords: Composite Securities, ETFs, Smart Beta, Index-Linked investment, Financial Innovation, Security Design, Informational Efficiency

JEL Classification: D40, D82, G14

Suggested Citation

Cong, Lin William and Xu, Douglas, Rise of Factor Investing: Asset Prices, Informational Efficiency, and Security Design (November 28, 2016). 29th Australasian Finance and Banking Conference 2016. Available at SSRN: https://ssrn.com/abstract=2800590 or http://dx.doi.org/10.2139/ssrn.2800590

Lin William Cong (Contact Author)

University of Chicago Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States

Douglas Xun Xu

University of Chicago ( email )

1101 East 58th Street
Chicago, IL 60637
United States

University of Chicago - Booth School of Business ( email )

5807 South Woodlawn Avenue
Chicago, IL 60637
United States

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