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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. An investor can hold assets through an index or an active fund. Investing in the active fund involves a time-varying cost, interpreted as managerial perk or ability. The investor responds to an increase in the cost by flowing out of the active and into the index fund. While prices of assets held by the active fund drop in anticipation of these outflows, the drop is expected to continue, leading to momentum. Because outflows push prices below fundamental values, expected returns eventually rise, leading to reversal. Besides momentum and reversal, fund flows generate comovement, lead-lag effects and amplification, with all effects being larger for assets with high idiosyncratic risk. The active-fund manager’s concern with commercial risk makes prices more volatile.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 14523.

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Date of creation: Dec 2008
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Publication status: published as Dimitri Vayanos & Paul Woolley, 2013. "An Institutional Theory of Momentum and Reversal," Review of Financial Studies, Society for Financial Studies, vol. 26(5), pages 1087-1145.
Handle: RePEc:nbr:nberwo:14523

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