Published online by Cambridge University Press: 18 August 2023
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.
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.