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Discontinued Positive Feedback Trading and the Decline of Return Predictability

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  • Ben-David, Itzhak
  • Li, Jiacui
  • Rossi, Andrea
  • Song, Yang

Abstract

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.

Suggested Citation

  • Ben-David, Itzhak & Li, Jiacui & Rossi, Andrea & Song, Yang, 2024. "Discontinued Positive Feedback Trading and the Decline of Return Predictability," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 59(7), pages 3062-3100, November.
    • Handle: RePEc:cup:jfinqa:v:59:y:2024:i:7:p:3062-3100_3
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    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage
    • G41 - Financial Economics - - Behavioral Finance - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making in Financial Markets

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