The Rise of Factor Investing: Asset Market Implications and “Passive” Security Design

We model financial innovations such as Exchange-Traded Funds, smart beta products, and many index-based vehicles as composite securities (CSs) that facilitate trading the common factors in assets’ liquidation values. Through accessing a larger basket of assets in endogenously chosen proportions, CSs reduce investors’ duplication of effort in trading multiple securities and attract more factor investors. We characterize analytically how competitive CS issuers in equilibrium optimally select liquid underlying assets representative of the factors, and find evidence in ETF data corroborating such active designs. CS trading also entails investors’ active (and strategic) decisions, consequently impounding more systematic (as opposed to asset-specific) information into prices. CS proliferation leads to greater informational efficiency, price variability, and co-movements in the underlying asset markets, as well as potentially heterogeneous effects on liquidity and asset-specific information acquisition/incorporation, depending on the importance of factors for asset value. The predictions explain and reconcile the rich (and often mixed) empirical observations in previous studies about various types of CSs.