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 National Bureau of Economic Research, Inc in its series NBER Working Papers with number
14523.
Length: Date of creation: Dec 2008 Date of revision: Handle: RePEc:nbr:nberwo:14523
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Find related papers by JEL classification: D5 - Microeconomics - - General Equilibrium and Disequilibrium D8 - Microeconomics - - Information, Knowledge, and Uncertainty G1 - Financial Economics - - General Financial Markets
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