Discontinued Positive Feedback Trading and the Decline of Momentum Profitability
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.
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