Discontinued Positive Feedback Trading and the Decline in Asset Pricing Factor Profitability
Charles A. Dice Center Working Paper No. 2021-03
56 Pages Posted: 22 Mar 2021 Last revised: 23 Mar 2021
Date Written: March 20, 2021
We show that a June 2002 reform in Morningstar’s mutual fund rating methodology led to substantial drop in the profitability of momentum-related asset pricing factors. Before the reform, funds pursuing the same investment style had correlated ratings heavily influenced by recent style performance. Therefore, ratings-chasing flows generated large style-level positive feedback trading. The reform decoupled ratings from style-level performance; consequently, factors that benefited from positive feedback trading experienced a precipitous return decline. The performance decline was limited to the U.S. market where the reform happened. We estimate that the reform explains 25%–50% of the long-term profitability drop in momentum-related factors.
Keywords: positive feedback trading, mutual funds, anomalies, momentum
JEL Classification: G11, G24, G41
Suggested Citation: Suggested Citation