Factor Demand and Factor Returns

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