Noise Trading and Asset Pricing Factors

Abstract

We demonstrate that a broad set of asset pricing factors (anomalies) are significantly exposed to "noise trader risk," and the noise trader risk is priced in factor premia. We first confirm that mutual funds' flow-induced trades of factors are uninformed as they generate a large price impact on factor returns, followed by a complete reversal. We then show asset pricing factors are subject to flow-driven noise trader risk in that expected variation (covariation) of flow-induced noise trading strongly forecast variance (covariance) of factor returns. Importantly, factor premia are higher when flow-driven noise trader risk is expected to be more salient.

Keywords: noise trader risk, factor premia, anomaly

JEL Classification: G10