Non-Fundamental Demand and Style Returns

We present causal evidence that non-fundamental correlated demand exerts a first-order impact on style returns. Mutual fund investors chase fund performance via Morningstar ratings, regardless of the rating methodology. Until June 2002, ratings depended on fund returns without any style adjustment, and thus mutual funds with the same investment style had highly correlated ratings. This methodology led rating chasing investors to direct capital into winning styles, exacerbating return chasing behavior. Capital flows exerted non-fundamental price pressure on the underlying stocks, creating style-momentum that reverted over time. In June 2002, Morningstar reformed its rating methodology so that ratings became equalized across styles. The reform demonstrates the causal impact of rating chasing: once the reform was implemented, style-level price pressures via the mutual fund channel immediately became muted. Furthermore, the dispersion in style performance declined sharply, and style momentum and reversal disappeared. We estimate that Morningstar rating chasing explains a substantial part of the size and value factors' time-series variation.