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An Institutional Theory of Momentum and Reversal

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Author Info
Vayanos, Dimitri
Woolley, Paul
Abstract

We propose a rational theory of momentum and reversal based on delegated portfolio management. A competitive investor can invest through an index fund or an active fund run by a manager with unknown ability. Following a negative cashflow shock to assets held by the active fund, the investor updates negatively about the manager's ability and migrates to the index fund. While prices of assets held by the active fund drop in anticipation of the investor's outflows, the drop is expected to continue, leading to momentum. Because outflows push prices below fundamental values, expected returns eventually rise, leading to reversal. Fund flows generate comovement and lead-lag effects, with predictability being stronger for assets with high idiosyncratic risk. We derive explicit solutions for asset prices, within a continuous-time normal-linear equilibrium.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 7068.

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Date of creation: Dec 2008
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Handle: RePEc:cpr:ceprdp:7068

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Related research
Keywords: delegated portfolio management; limits to arbitrage; momentum; reversal;

Find related papers by JEL classification:
D5 - Microeconomics - - General Equilibrium and Disequilibrium
D8 - Microeconomics - - Information, Knowledge, and Uncertainty
G1 - Financial Economics - - General Financial Markets

This paper has been announced in the following NEP Reports:

References listed on IDEAS
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  1. Vincent Glode & Burton Hollifield & Marcin Kacperczyk & Shimon Kogan, 2009. "Is Investor Rationality Time Varying? Evidence from the Mutual Fund Industry," NBER Working Papers 15038, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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