Non-Fundamental Demand and Style Returns

54 Pages Posted: 16 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 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.

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Suggested Citation

Ben-David, Itzhak and Li, Jiacui and Rossi, Andrea and Song, Yang, Non-Fundamental Demand and Style Returns (November 2020). NBER Working Paper No. w28103, Available at SSRN: https://ssrn.com/abstract=3731273

Itzhak Ben-David (Contact Author)

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Jiacui Li

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

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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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