Factor Demand and Factor Returns
55 Pages Posted: 13 Feb 2019 Last revised: 13 Jan 2021
Date Written: February 1, 2019
A mutual fund’s demand for a pricing factor, measured by the loading of the fund’s returns on the factor’s returns, is persistent over time. When stock characteristics are time-varying and change frequently, persistence in factor demand generates a need for rebalancing. This rebalancing motive, in turn, leads to predictable trading from mutual funds and contributes to cross-sectional return predictability. In particular, when there is a “mismatch” between a stock’s characteristic and the underlying funds’ demand for that characteristic, the “mismatched” stock will face selling pressure from the underlying funds and subsequently earn lower returns. Double-sorting on stocks’ characteristics and mutual funds’ factor demand refines value and momentum strategies, generating abnormal returns that cannot be explained by subsequent fundamentals or retail trading flows.
Keywords: Factor Rebalancing, Mutual Funds, Price Pressure, Factor Returns
JEL Classification: G12, G23, G40
Suggested Citation: Suggested Citation