Discontinued Positive Feedback Trading and the Decline of Return Predictability
Charles A. Dice Center Working Paper No. 2021-03
50 Pages Posted: 22 Mar 2021 Last revised: 16 May 2022
Date Written: May 15, 2022
We show that demand effects generated by institutional frictions can influence systematic return predictability patterns in stocks and mutual funds. Identification relies on a reform to the Morningstar rating system, which we show caused a structural break in style-level positive feedback trading by mutual funds. As a result, momentum-related factors in stocks, as well as performance persistence and the "dumb money effect" in mutual funds, experienced sharp decline. Consistent with the proposed channel, return predictability declined right after the reform, was limited to the U.S. market, and was concentrated in factors and mutual funds most exposed to the mechanism.
Keywords: positive feedback trading, mutual funds, anomalies, momentum, factor momentum
JEL Classification: G11, G24, G41
Suggested Citation: Suggested Citation