The Drivers and Inhibitors of Factor Investing

Abstract

I model the equilibrium asset allocations when households can invest directly, search for factor (smart-beta and ETFs) investments or fundamental (stock-picking) investments. Managers endogenously choose to specialize in factor or fundamental information given the equilibrium fee structure. Fundamental managers can opt to be opportunistic “closet indexers.” I show that wealth inequality increases demand for factor investing: fundamental investing attracts the wealthiest households, who are more willing to detect closet indexing. Fundamental managers have to compete more aggressively through information acquisition, which lowers their excess returns and thus delegation fees. The reduced fees earned by fundamental managers force factor managers to lower their fees, making factor investing more attractive. However, the equilibrium fraction of capital allocated to factor investing can never reach 100 percent: the ceiling is determined by the endogenous level of opportunism in the fundamental investment industry.