How Mutual Fund Ratings Create Style-Level Price Pressure

Summary

This study examines whether investors chasing Morningstar mutual fund ratings can move stock prices through fund flows. Before Morningstar’s June 2002 methodology change, ratings were closely tied to broad fund performance and therefore favored some investment styles. The revised approach rated funds within styles, making ratings more balanced across them. The article traces how rating changes affect fund flows, flow-driven stock trading, and subsequent returns, then aggregates the effects across style portfolios.

Evidence from historical US fund and stock data links rating changes to higher flows and temporary price pressure, followed by reversal. Before the reform, highly rated styles attracted more capital and showed stronger momentum and later reversal; after it, differences in style flows and returns narrowed. Event analyses and checks of fundamentals and other institutional trading support the interpretation that the reform changed rating-driven demand. The results show one channel for non-fundamental demand to affect systematic returns, but rely on a particular historical reform and market setting; they do not establish that rating-based strategies will work in other periods or markets.

Key ideas

• Investors continued to respond to fund ratings after Morningstar changed its rating method.
• Before the reform, ratings concentrated flows in certain styles, creating price pressure and later return reversals.
• The style-based rating method spread rating-driven flows more evenly and reduced differences in style returns.
• The study uses flow regressions, return predictability tests, and an event study around the reform to assess the mechanism.
• Historical evidence from US mutual funds may not generalize to other markets or periods.

Tags

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.