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Although hidden, the implicit market impact costs of factor investing may substantially erode a strategy’s expected excess returns. The rebalancing data of a suite of large and long-standing factor-investing indexes are used in this study to model these market impact costs. A framework to assess the costs of rebalancing activities is introduced. These costs are then attributed to characteristics that intuitively describe the strategies’ demands on liquidity, such as rate of turnover and the concentration of turnover. A number of popular factor-investing implementations are identified, and the authors discuss how their index construction methods, when thoughtfully designed, can reduce market impact costs.

About the Author(s)

Feifei Li

Feifei Li is director of investment strategy at Research Affiliates, LLC, Newport Beach, California.

Tzee-Man Chow

Tzee-Man Chow is senior vice president and head of smart beta at Research Affiliates, LLC, Newport Beach, California.

Alex Pickard CFA

Alex Pickard, CFA, is senior analyst, research, at Research Affiliates, LLC, Newport Beach, California.

Yadwinder Garg CFA

Yadwinder Garg, CFA, is senior associate analyst, disciplined equities, BMO Asset Management, Inc., Toronto.