Factor Demand and Factor Returns

Abstract

We propose a novel source of predictable price pressure resulting from mutual funds' factor rebalancing behavior. When a fund's factor demand is persistent, it needs to frequently rebalance its portfolio's factor exposure, leading to stock-level predictable trading and price pressure. We confirm the persistence of factor demand and show that factor rebalancing is prevalent and operates independently from trading induced by retail flows. Consistent with demand-induced price pressure, stocks whose characteristics are mismatched with the underlying funds' factor demand experience lower returns, whereas well-matched stocks experience higher returns. We rule out alternative explanations based on private information, skills, and herding.

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

JEL Classification: G12, G23, G40