Non-Fundamental Demand and Style Returns

Fisher College of Business Working Paper No. 2020-03-026

Charles A. Dice Working Paper No. 2020-26

54 Pages Posted: 12 Nov 2020

See all articles by Itzhak Ben-David

Itzhak Ben-David

Ohio State University (OSU) - Department of Finance; National Bureau of Economic Research (NBER)

Jiacui Li

David Eccles School of Business, University of Utah

Andrea Rossi

University of Arizona - Department of Finance

Yang Song

University of Washington - Michael G. Foster School of Business

Multiple version iconThere are 2 versions of this paper

Date Written: November 7, 2020

Abstract

We present causal evidence that non-fundamental correlated demand exerts a first-order impact on style returns. Mutual fund investors chase fund performance via Morningstar ratings, regardless of the rating methodology. Until June 2002, ratings depended on fund returns without any style adjustment, and thus mutual funds with the same investment style had highly correlated ratings. This methodology led rating chasing investors to direct capital into winning styles, exacerbating return chasing behavior. Capital flows exerted non-fundamental price pressure on the underlying stocks, creating style-momentum that reverted over time. In June 2002, Morningstar reformed its rating methodology so that ratings became equalized across styles. The reform demonstrates the causal impact of rating chasing: once the reform was implemented, style-level price pressures via the mutual fund channel immediately became muted. Furthermore, the dispersion in style performance declined sharply, and style momentum and reversal disappeared. We estimate that Morningstar rating chasing explains a substantial part of the size and value factors' time-series variation.

Keywords: Correlated demand, style investing, mutual funds, momentum

JEL Classification: G11, G24, G41

Suggested Citation

Ben-David, Itzhak and Li, Jiacui and Rossi, Andrea and Song, Yang, Non-Fundamental Demand and Style Returns (November 7, 2020). Fisher College of Business Working Paper No. 2020-03-026, Charles A. Dice Working Paper No. 2020-26, Available at SSRN: https://ssrn.com/abstract=3728056 or http://dx.doi.org/10.2139/ssrn.3728056

Itzhak Ben-David (Contact Author)

Ohio State University (OSU) - Department of Finance ( email )

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HOME PAGE: http://fisher.osu.edu/fin/faculty/Ben-David/index.htm

National Bureau of Economic Research (NBER) ( email )

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HOME PAGE: http://fisher.osu.edu/fin/faculty/Ben-David/

Jiacui Li

David Eccles School of Business, University of Utah ( email )

8123 SFEBB, 1655 Campus Center Dr
Salt Lake City, UT 84112
United States

HOME PAGE: http://https://www.jiacui-li.com/

Andrea Rossi

University of Arizona - Department of Finance ( email )

McClelland Hall
P.O. Box 210108
Tucson, AZ 85721-0108
United States

Yang Song

University of Washington - Michael G. Foster School of Business ( email )

Box 353200
Seattle, WA 98195-3200
United States

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