Naïve Style-level Feedback Trading in Passive Funds

Author Information:

Markus Broman (Whitman School of Management, Syracuse University)

Year of Publication:

Journal of Financial and Quantitative Analysis (2021)

Summary of Findings:

Passively managed Exchange-Traded Funds (ETFs) are used by investors, especially less sophisticated institutions, to chase recent style performance.

Research Questions:

1. Why do investors chase past-style performance?
2. Who chases past style performance (institutional or retail investors)?
3. What are the implications for asset prices?

What we know:

Several recent theoretical models predict that naïve return chasers (“positive feedback traders”) can destabilize stock prices and thereby threaten the efficiency of financial markets. The empirical evidence on such behavior is scant, partly because it is difficult to separate naïve return chasing from informed return chasing (i.e., learning about fund manager skills). Learning about past performance is not, however, possible in the case of passively managed and transparent ETFs.

Novel Findings:

I find that investors in general, and less sophisticated institutional investors in particular, engage in naïve return chasing over the short term. These style-level demand shocks push asset prices temporarily away from fundamentals, which suggests that naïve style-level return chasing by less sophisticated market participants can destabilize financial markets in the short run.

Full Citations:

Broman (2021): Naïve Style-level Feedback Trading in Passive Funds, Journal of Financial and Quantitative Analysis, forthcoming.

Abstract:

Passive Exchange-Traded Funds (ETFs) are ideally suited to style-level feedback trading because of their high liquidity, ease of short-selling, and pure play on investment styles. I find strong evidence of short-term style momentum trading in ETFs. Institutional investors that use ETFs do not act as arbitrageurs by trading against style momentum. Institutions, especially less sophisticated ones, are themselves style momentum traders. Moreover, recent style-level demand predicts style-level return reversals. These findings suggest that uninformed positive feedback trading by less sophisticated market participants can destabilize financial markets in the short run.