Hostname: page-component-78c5997874-j824f Total loading time: 0 Render date: 2024-11-18T13:50:55.191Z Has data issue: false hasContentIssue false
  • English
  • Français

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 jiacui.li@eccles.utah.edu
Andrea Rossi
Affiliation:
The University of Arizona Eller College of Management rossi2@arizona.edu
Yang Song
Affiliation:
University of Washington Foster School of Business songy18@uw.edu
*
ben-david.1@osu.edu (corresponding author)
Rights & Permissions [Opens in a new window]

Abstract

Core share and HTML view are not available for this content. However, as you have access to this content, a full PDF is available via the ‘Save PDF’ action button.

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.

References

Adelino, M.; Cheong, C.; Choi, J.; and Oh, J. Y. J.. “Mutual Fund Flows and the Supply of Capital in Municipal Financing.” NBER Working Paper No. 30980 (2023).Google Scholar
An, Y. “Flow-Based Arbitrage Pricing Theory.” Working Paper, Johns Hopkins University (2022).Google Scholar
Aragon, G. O.; Li, E.; and Lindsey, L. A.. “Exploration or Exploitation? Hedge Funds in Venture Capital.” Working Paper, Arizona State University (2018).Google Scholar
Arnott, R. D.; Clements, M.; Kalesnik, V.; and Linnainmaa, J. T.. “Factor Momentum.” Review of Financial Studies, 36 (2023), 3034–3070.Google Scholar
Barber, B. M.; Huang, X.; and Odean, T.. “Which Factors Matter to Investors? Evidence from Mutual Fund Flows.” Review of Financial Studies, 29 (2016), 2600–2642.Google Scholar
Barberis, N., and Shleifer, A.. “Style Investing.” Journal of Financial Economics, 68 (2003), 161–199.Google Scholar
Ben-David, I.; Franzoni, F.; and Moussawi, R.. “Do ETFs Increase Volatility?” Journal of Finance, 73 (2018), 2471–2535.Google Scholar
Ben-David, I.; Franzoni, F.; Moussawi, R.; and Sedunov, J.. “The Granular Nature of Large Institutional Investors.” Management Science, 67 (2021), 6629–6659.Google Scholar
Ben-David, I.; Li, J.; Rossi, A.; and Song, Y.. “Ratings-Driven Demand and Systematic Price Fluctuations.” Review of Financial Studies, 35 (2022a), 2790–2838.Google Scholar
Ben-David, I.; Li, J.; Rossi, A.; and Song, Y.. “What Do Mutual Fund Investors Really Care About?” Review of Financial Studies, 35 (2022b), 1723–1774.Google Scholar
Berk, J. B., and Green, R. C.. “Mutual Fund Flows and Performance in Rational Markets.” Journal of Political Economy, 112 (2004), 1269–1295.Google Scholar
Blitz, D.; Huij, J.; and Martens, M.. “Residual Momentum.” Journal of Empirical Finance, 18 (2011), 506–521.Google Scholar
Boyer, B. H. “Style-Related Comovement: Fundamentals or Labels?” Journal of Finance, 66 (2011), 307–332.Google Scholar
Brown, D. C.; Davies, S.; and Ringgenberg, M.. “ETF Arbitrage, Non-Fundamental Demand, and Return Predictability.” Review of Finance, 25 (2021), 937–972.Google Scholar
Calluzzo, P.; Moneta, F.; and Topaloglu, S.. “When Anomalies Are Publicized Broadly, Do Institutions Trade Accordingly?” Management Science, 65 (2019), 4555–4574.Google Scholar
Carhart, M. M. “On Persistence in Mutual Fund Performance.” Journal of Finance, 52 (1997), 57–82.Google Scholar
Chang, Y.-C.; Hong, H.; and Liskovich, I.. “Regression Discontinuity and the Price Effects of Stock Market Indexing.” Review of Financial Studies, 28 (2015), 212–246.Google Scholar
Chen, A. Y., and Zimmermann, T.. “Open Source Cross-Sectional Asset Pricing.” Critical Finance Review, 27 (2022), 207–264.Google Scholar
Chen, H. “Cash Induced Demand.” Journal of Financial and Quantitative Analysis, 59 (2024), 195–220.Google Scholar
Chen, Y.; Da, Z.; and Huang, D.. “Arbitrage Trading: The Long and the Short of It.” Review of Financial Studies, 32 (2019), 1608–1646.Google Scholar
Chevalier, J., and Ellison, G.. “Risk Taking by Mutual Funds as a Response to Incentives.” Journal of Political Economy, 105 (1997), 1167–1200.Google Scholar
Cho, T. “Turning Alphas into Betas: Arbitrage and Endogenous Risk.” Journal of Financial Economics, 137 (2020), 550–570.Google Scholar
Choi, J. J., and Zhao, K.. “Carhart (1997) Mutual Fund Performance Persistence Disappears Out of Sample.” Critical Finance Review, 10 (2021), 263–270.Google Scholar
Chordia, T.; Subrahmanyam, A.; and Tong, Q.. “Have Capital Market Anomalies Attenuated in the Recent Era of High Liquidity and Trading Activity?” Journal of Accounting and Economics, 58 (2014), 41–58.Google Scholar
Cochrane, J. H. “Presidential Address: Discount Rates.” Journal of Finance, 66 (2011), 1047–1108.Google Scholar
Corwin, S. A., and Schultz, P.. “A Simple Way to Estimate Bid–Ask Spreads from Daily High and Low Prices.” Journal of Finance, 67 (2012), 719–760.Google Scholar
Coval, J., and Stafford, E.. “Asset Fire Sales (and Purchases) in Equity Markets.” Journal of Financial Economics, 86 (2007), 479–512.Google Scholar
Daniel, K. D., and Moskowitz, T. J.. “Momentum Crashes.” Journal of Financial Economics, 122 (2016), 221–247.Google Scholar
De Bondt, W. F., and Thaler, R.. “Does the Stock Market Overreact?” Journal of Finance, 40 (1985), 793–805.Google Scholar
Del Guercio, D., and Tkac, P. A.. “Star Power: The Effect of Morningstar Ratings on Mutual Fund Flow.” Journal of Financial and Quantitative Analysis, 43 (2008), 907–936.Google Scholar
Ehsani, S., and Linnainmaa, J. T.. “Factor Momentum and the Momentum Factor.” Journal of Finance, 77 (2022), 1877–1919.Google Scholar
Evans, R. B., and Fahlenbrach, R.. “Institutional Investors and Mutual Fund Governance: Evidence from Retail–Institutional Fund Twins.” Review of Financial Studies, 25 (2012), 3530–3571.Google Scholar
Evans, R. B., and Sun, Y.. “Models or Stars: The Role of Asset Pricing Models and Heuristics in Investor Risk Adjustment.” Review of Financial Studies, 34 (2021), 67–107.Google Scholar
Falck, A.; Rej, A.; and Thesmar, D.. “When Do Systematic Strategies Decay?” Quantitative Finance, 22 (2022), 1955–1969.Google Scholar
Frazzini, A., and Lamont, O. A.. “Dumb Money: Mutual Fund Flows and the Cross-Section of Stock Returns.” Journal of Financial Economics, 88 (2008), 299–322.Google Scholar
Froot, K., and Teo, M.. “Style Investing and Institutional Investors.” Journal of Financial and Quantitative Analysis, 43 (2008), 883–906.Google Scholar
Gabaix, X., and Koijen, R. S.. “In Search of the Origins of Financial Fluctuations: The Inelastic Markets Hypothesis.” Working Paper, Harvard University (2022).Google Scholar
George, T. J., and Hwang, C.-Y.. “The 52-Week High and Momentum Investing.” Journal of Finance, 59 (2004), 2145–2176.Google Scholar
Green, J.; Hand, J. R.; and Soliman, M. T.. “Going, Going, Gone? The Apparent Demise of the Accruals Anomaly.” Management Science, 57 (2011), 797–816.Google Scholar
Green, J.; Hand, J. R.; and Zhang, X. F.. “The Characteristics that Provide Independent Information About Average US Monthly Stock Returns.” Review of Financial Studies, 30 (2017), 4389–4436.Google Scholar
Gupta, T., and Kelly, B. T.. “Factor Momentum Everywhere.” Journal of Portfolio Management, 45 (2019), 13–36.Google Scholar
Haddad, V.; Huebner, P.; and Loualiche, E.. “How Competitive is the Stock Market? Theory, Evidence from Portfolios, and Implications for the Rise of Passive Investing.” Working Paper, SSRN (2021).Google Scholar
Han, X.; Roussanov, N. L.; and Ruan, H.. “Mutual Fund Risk Shifting and Risk Anomalies.” Working Paper, University of Pennsylvania (2021).Google Scholar
Hanson, S. G., and Sunderam, A.. “The Growth and Limits of Arbitrage: Evidence from Short Interest.” Review of Financial Studies, 27 (2013), 1238–1286.Google Scholar
Harris, L., and Gurel, E.. “Price and Volume Effects Associated with Changes in the S&P 500 List: New Evidence for the Existence of Price Pressures.” Journal of Finance, 41 (1986), 815–829.Google Scholar
Harvey, C. R. “Presidential Address: The Scientific Outlook in Financial Economics.” Journal of Finance, 72 (2017), 1399–1440.Google Scholar
Harvey, C. R.; Liu, Y.; and Zhu, H.. “… and the Cross-Section of Expected Returns.” Review of Financial Studies, 29 (2016), 5–68.Google Scholar
He, Z., and Krishnamurthy, A.. “Intermediary Asset Pricing.” American Economic Review, 103 (2013), 732–770.Google Scholar
Hendershott, T.; Jones, C. M.; and Menkveld, A. J.. “Does Algorithmic Trading Improve Liquidity?” Journal of Finance, 66 (2011), 1–33.Google Scholar
Heston, S. L., and Sadka, R.. “Seasonality in the Cross-Section of Stock Returns.” Journal of Financial Economics, 87 (2008), 418–445.Google Scholar
Hou, K.; Xue, C.; and Zhang, L.. “Replicating Anomalies.” Review of Financial Studies, 33 (2020), 2019–2133.Google Scholar
Huang, S.; Song, Y.; and Xiang, H.. “Noise Trading and Asset Pricing Factors.” Working Paper, University of Washington (2020).Google Scholar
Huang, S.; Song, Y.; and Xiang, H.. “The Smart Beta Mirage.” Journal of Financial and Quantitative Analysis, forthcoming (2024).Google Scholar
Huebner, P. “The Making of Momentum: A Demand-System Perspective.” Working Paper, University of California at Los Angeles (2023).Google Scholar
Jegadeesh, N., and Titman, S.. “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency.” Journal of Finance, 48 (1993), 65–91.Google Scholar
Jensen, T. I.; Kelly, B. T.; and Pedersen, L. H.. “Is There a Replication Crisis in Finance?” Journal of Finance, 78 (2023), 2465–2518.Google Scholar
Johnson, T. C. “Dynamic Liquidity in Endowment Economies.” Journal of Financial Economics, 80 (2006), 531–562.Google Scholar
Jones, C. S., and Mo, H.. “Out-of-Sample Performance of Mutual Fund Predictors.” Review of Financial Studies, 34 (2021), 149–193.Google Scholar
Khandani, A. E., and Lo, A. W.. “Illiquidity Premia in Asset Returns: An Empirical Analysis of Hedge Funds, Mutual Funds, and US Equity Portfolios.” Quarterly Journal of Finance, 1 (2011), 205–264.Google Scholar
Kim, S. H. “Do Mutual Funds Manipulate Star Ratings? Evidence from Portfolio Pumping.” Working Paper, University of Texas at Dallas (2020).Google Scholar
Kim, Y. H.; Ivkovich, Z.; and Muravyev, D.. “Causal Effect of Information Costs on Asset Pricing Anomalies.” Working Paper, Michigan State University (2023).Google Scholar
Koijen, R. S., and Yogo, M.. “A Demand System Approach to Asset Pricing.” Journal of Political Economy, 127 (2019), 1475–1515.Google Scholar
Lee, J., and Ogden, J. P.. “Did the Profitability of Momentum and Reversal Strategies Decline with Arbitrage Costs After the Turn of the Millennium?” Journal of Portfolio Management, 41 (2015), 70–83.Google Scholar
Lewellen, J. “The Cross-Section of Expected Stock Returns.” Critical Finance Review, 4 (2015), 1–44.Google Scholar
Li, J. “What Drives the Size and Value Factors?” Review of Asset Pricing Studies, 12 (2022), 845–885.Google Scholar
Li, J., and Lin, Z.. “Prices Are Less Elastic at More Aggregate Levels.” Working Paper, University of Utah (2022).Google Scholar
Lou, D. “A Flow-Based Explanation for Return Predictability.” Review of Financial Studies, 25 (2012), 3457–3489.Google Scholar
Lou, D., and Polk, C.. “Comomentum: Inferring Arbitrage Activity from Return Correlations.” Review of Financial Studies, 35 (2022), 3272–3302.Google Scholar
Marquering, W.; Nisser, J.; and Valla, T.. “Disappearing Anomalies: A Dynamic Analysis of the Persistence of Anomalies.” Applied Financial Economics, 16 (2006), 291–302.Google Scholar
McLean, R. D., and Pontiff, J.. “Does Academic Research Destroy Stock Return Predictability?” Journal of Finance, 71 (2016), 5–32.Google Scholar
Morningstar. “The Morningstar Rating for Funds.” White Paper, Morningstar (2016).Google Scholar
Moskowitz, T. J., and Grinblatt, M.. “Do Industries Explain Momentum?” Journal of Finance, 54 (1999), 1249–1290.Google Scholar
Mullally, K., and Rossi, A.. “Moving the Goalposts? Mutual Fund Benchmark Changes and Performance Manipulation.” Working Paper, University of Arizona (2022).Google Scholar
Novy-Marx, R. “Is Momentum Really Momentum?” Journal of Financial Economics, 103 (2012), 429–453.Google Scholar
Parker, J.; Schoar, A.; and Sun, Y.. “Retail Financial Innovation and Stock Market Dynamics: The Case of Target Date Funds.” Journal of Finance, 78 (2023), 2673–2723.Google Scholar
Pástor, L.; Stambaugh, R. F.; and Taylor, L. A.. “Fund Tradeoffs.” Journal of Financial Economics, 138 (2020), 614–634.Google Scholar
Pavlova, A., and Sikorskaya, T.. “Benchmarking Intensity.” Review of Financial Studies, 36 (2023), 859–903.Google Scholar
Peng, C., and Wang, C.. “Factor Demand and Factor Returns.” Working Paper, University of Notre Dame (2022).Google Scholar
Petajisto, A. “Why Do Demand Curves for Stocks Slope Down?” Journal of Financial and Quantitative Analysis, 44 (2009), 1013–1044.Google Scholar
Reuter, J., and Zitzewitz, E.. “How Much Does Size Erode Mutual Fund Performance? A Regression Discontinuity Approach.” Review of Finance, 25 (2021), 1395–1432.Google Scholar
Schmickler, S. “Identifying the Price Impact of Fire Sales Using High-Frequency Surprise Mutual Fund Flows.” Working Paper, Princeton University (2020).Google Scholar
Sensoy, B. A. “Performance Evaluation and Self-Designated Benchmark Indexes in the Mutual Fund Industry.” Journal of Financial Economics, 92 (2009), 25–39.Google Scholar
Shleifer, A. “Do Demand Curves for Stocks Slope Down?” Journal of Finance, 41 (1986), 579–590.Google Scholar
Teo, M., and Woo, S.-J.. “Style Effects in the Cross-Section of Stock Returns.” Journal of Financial Economics, 74 (2004), 367–398.Google Scholar
van der Beck, P. “On the Estimation of Demand-Based Asset Pricing Models.” Working Paper, Ecole Polytechnique Fédérale de Lausanne (2022).Google Scholar
Wahal, S., and Yavuz, M. D.. “Style Investing, Comovement and Return Predictability.” Journal of Financial Economics, 107 (2013), 136–154.Google Scholar
Wurgler, J., and Zhuravskaya, E.. “Does Arbitrage Flatten Demand Curves for Stocks?” Journal of Business, 75 (2002), 583–608.Google Scholar
Zheng, L. “Is Money Smart? A Study of Mutual Fund Investors’ Fund Selection Ability.” Journal of Finance, 54 (1999), 901–933.Google Scholar