Which Investors Drive Factor Returns?

Abstract

Different investors hold different portfolios. To explain this phenomenon, I build a model in which investors have different information processing capabilities. The model predicts that highly capable investors specialize in factor timing, hold more volatile and dispersed portfolios, and reduce average risk premia and volatility. Using novel empirical measures of investors’ capabilities and information choices, I find that hedge funds are the most capable investors, while insurance companies and pension funds are the least. Variation in factor timing ability is the primary driver of these differences. Investors’ portfolios exhibit properties consistent with the model’s predictions. Using a demand system approach, I show that hedge funds have the greatest per-dollar impact on expected returns, shrinking expected returns in the factor zoo by nearly 40% per $1 trillion of invested capital.

Keywords: rational inattention, portfolio choice, demand system, factor zoo, institutional investors

JEL Classification: D8, G11, G12, G14, G23