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.
Authors
- Acknowledgements & Disclosure
- We thank Nicholas Barberis, Lauren Cohen, Sylvester Flood (Morningstar), Umit Gurun, Paul Kaplan (Morningstar), Dong Lou, Chris Malloy, Andrei Shleifer for helpful comments. We thank seminar participants at The Ohio State University, the University of Utah, the University of Washington, Hong Kong University of Science and Technology, and Arrowstreet Capital, as well as the National Bureau of Economic Research Behavior Finance Workshop for comments and George Aragon for sharing data. Ben-David is with The Ohio State University and the National Bureau of Economic Research, Li is with University of Utah, Rossi is with the University of Arizona, and Song is with the University of Washington. Ben-David is a co-founder and a partner in an investment advisor. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.
- DOI
- https://doi.org/10.3386/w28624
- Published in
- United States of America