Factor Demand and Factor Returns

59 Pages Posted: 13 Feb 2019 Last revised: 6 Oct 2021

See all articles by Cameron Peng

Cameron Peng

London School of Economics & Political Science (LSE) - Department of Finance

Chen Wang

University of Notre Dame - Mendoza College of Business

Date Written: October 3, 2021

Abstract

We show that mutual funds' factor demand drives cross-sectional stock return predictability; it explains why value and momentum prevail among certain stocks and fail among others. A fund's factor demand, measured by the loadings of fund returns on factor returns, is highly persistent over time. Persistence in factor demand combined with time-varying stock characteristics generates a strong rebalancing motive—a phenomenon we term "factor rebalancing"—that leads to predictable trading. The associated price pressure results in stronger value and momentum returns for stocks with characteristics well-matched with the underlying funds' factor demand. Mismatched stocks, in contrast, face more selling pressure in the short run and experience lower factor returns. By quantifying the scale of factor rebalancing and its price impact, we estimate an average factor demand elasticity of -0.23.

Keywords: Factor Rebalancing, Mutual Funds, Price Pressure, Factor Returns

JEL Classification: G12, G23, G40

Suggested Citation

Peng, Cameron and Wang, Chen, Factor Demand and Factor Returns (October 3, 2021). Available at SSRN: https://ssrn.com/abstract=3327849 or http://dx.doi.org/10.2139/ssrn.3327849

Cameron Peng (Contact Author)

London School of Economics & Political Science (LSE) - Department of Finance ( email )

United Kingdom

Chen Wang

University of Notre Dame - Mendoza College of Business ( email )

Notre Dame, IN 46556-5646
United States

HOME PAGE: http://chenwang.one/

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