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An Institutional Theory of Momentum and Reversal

  • Dimitri Vayanos
  • Paul Woolley

We propose a theory of momentum and reversal based on flows between investment funds. Flows are triggered by changes in fund managers' efficiency, which investors either observe directly or infer from past performance. Momentum arises if flows exhibit inertia, and because rational prices underreact to expected future flows. Reversal arises because flows push prices away from fundamental values. Besides momentum and reversal, flows generate comovement, lead-lag effects, and amplification, with these being larger for high idiosyncratic risk assets. A calibration of our model using evidence on mutual fund returns and flows generates sizeable Sharpe ratios for momentum and value strategies. The Author 2013. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oup.com., Oxford University Press.

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Article provided by Society for Financial Studies in its journal The Review of Financial Studies.

Volume (Year): 26 (2013)
Issue (Month): 5 ()
Pages: 1087-1145

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Handle: RePEc:oup:rfinst:v:26:y:2013:i:5:p:1087-1145
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