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Discontinued Positive Feedback Trading and the Decline of Momentum Profitability

Author

Listed:
  • Ben-David, Itzhak

    (Ohio State U)

  • Li, Jiacui

    (U of Utah)

  • Rossi, Andrea

    (U of Arizona)

  • Song, Yang

    (U of Washington)

Abstract

We argue that the June 2002 reform in Morningstar's mutual fund rating methodology explains a sizeable amount of the profitability decline in momentum-related factors and factor momentum strategies. Before the reform, fund ratings heavily depended on recent investment style performance, and ratings-chasing flows led to large style-level positive feedback trading. The reform disrupted this process, and factors that benefit from positive feedback trading experienced a precipitous return decline. The performance decline was specific to momentum-related strategies and was also limited to the U.S. market where the reform happened. Further validating the mechanism, factors that are negatively affected by the reform experienced a sharp return "kink" in mid 2002, while the unaffected factors did not. We estimate that the reform explains approximately a third and two thirds of the post-2002 profitability drop in momentum-related factors and factor momentum, respectively.

Suggested Citation

  • Ben-David, Itzhak & Li, Jiacui & Rossi, Andrea & Song, Yang, 2021. "Discontinued Positive Feedback Trading and the Decline of Momentum Profitability," Working Paper Series 2021-03, Ohio State University, Charles A. Dice Center for Research in Financial Economics.
    • Handle: RePEc:ecl:ohidic:2021-03
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    File URL: http://ssrn.com/abstract=3808853
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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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