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Discontinued Positive Feedback Trading and the Decline of Return Predictability

Published online by Cambridge University Press:  18 August 2023

Itzhak Ben-David Open the ORCID record for Itzhak Ben-David [Opens in a new window] ,
Jiacui Li ,
Andrea Rossi  and
Yang Song
Itzhak Ben-David*
Affiliation:
The Ohio State University Fisher College of Business and NBER
Jiacui Li
Affiliation:
The University of Utah Eccles School of Business [email protected]
Andrea Rossi
Affiliation:
The University of Arizona Eller College of Management [email protected]
Yang Song
Affiliation:
University of Washington Foster School of Business [email protected]
*
[email protected] (corresponding author)
Rights & Permissions [Opens in a new window]

Abstract

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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 a 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.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , First View , pp. 1 - 39
Creative Commons
Creative Common License - CCCreative Common License - BY
This is an Open Access article, distributed under the terms of the Creative Commons Attribution licence (http://creativecommons.org/licenses/by/4.0), which permits unrestricted re-use, distribution and reproduction, provided the original article is properly cited.
Copyright
© The Author(s), 2023. Published by Cambridge University Press on behalf of the Michael G. Foster School of Business, University of Washington

Footnotes

We thank Nicholas Barberis, Huaizhi Chen, Thummim Cho, Lauren Cohen, Richard Evans (the referee), Thierry Foucault (the editor), Sylvester Flood (Morningstar), Umit Gurun, Bing Han, Paul Kaplan (Morningstar), Dong Lou, Chris Malloy, Christopher Schwarz, John Shim, Andrei Shleifer, Yang Sun, Motohiro Yogo, and Lu Zheng for helpful comments. We thank seminar participants at The Ohio State University, the University of Utah, the University of Washington, the University of California–Irvine, Cornell University, Hong Kong University of Science and Technology, and Arrowstreet Capital, as well as 2021 WFA, 2021 EFA, 2022 MFA, 2023 AFA, Pacific Northwest Finance Conference, and the National Bureau of Economic Research Behavior Finance Workshop participants for comments and George Aragon for sharing data. Ben-David is a co-founder and a partner in an investment advisor.

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