Factor and Stock-Specific Disagreement and Trading Flows

Abstract

We study how disagreement on both factor and stock-specific risk exposures across many agents and securities impact asset prices. Our theoretical analyses predict that disagreement about factor dynamics drives larger flows into portfolios that are more exposed to the factors. Consequently, these concentrated bets on the factor lead to higher volatility and reduced diversification benefits. We then test these predictions using a novel empirical setting – exchange-traded funds (ETFs). We find that when factor disagreement rises, funds flow into the ETFs that mimic the factor. However, these increased flows induce high forward looking volatility of, and correlation risk within, the ETF.

Keywords: Disagreement, ETF, Lucas Orchard, Volatility and Correlation Risk

JEL Classification: D81, G11, G12