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An institutional theory of momentum and reversal

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  • Dimitri Vayanos
  • Paul Woolley

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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File URL: http://eprints.lse.ac.uk/24423/
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Bibliographic Info

Paper provided by London School of Economics and Political Science, LSE Library in its series LSE Research Online Documents on Economics with number 24423.

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Length: 75 pages
Date of creation: 28 Nov 2008
Date of revision:
Handle: RePEc:ehl:lserod:24423

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