This paper reveals that the discrete nature of Morningstar ratings gives mutual fund managers powerful incentives to inflate their month-end performance. Compared to their distant peers, mutual funds near a rating threshold experience substantially larger gains on the last trading day of the month, which partially dissipates on the next trading day. This effect is more pronounced among funds with a greater incentive and ability to pump up their portfolios. In addition, stocks predominantly held by funds close to a rating cutoff also earn significantly higher returns at the month-end, especially during the last minutes of the trading session. Less liquid stocks are naturally more exposed to pumping. Placebo tests exploiting a change in the Morningstar rating methodology around June 2002 provide corroborating evidence that the threshold effect of star ratings on portfolio pumping is likely causal.

Keywords: Morningstar ratings, mutual funds, portfolio pumping, price manipulation, threshold effects​