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An institutional Theory of Momentum and Reversal

  • Dimitri Vayanos


  • Paul Woolley


We propose a rational theory of momentum and reversal based on delegated portfolio management. Flows between investment funds are triggered by changes in fund managers' e±ciency, which investors either observe directly or infer from past performance. Momentum arises if fund °ows exhibit inertia, and because rational prices do not fully adjust to re°ect future °ows. Reversal arises because °ows push prices away from fundamental values. Besides momentum and reversal, fund °ows generate comovement, lead-lag e®ects and ampli¯cation, with all e®ects being larger for assets with high idiosyncratic risk. Managers' concern with commercial risk can make prices more volatile.

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Paper provided by Financial Markets Group in its series FMG Discussion Papers with number dp666.

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Date of creation: Jan 2011
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Handle: RePEc:fmg:fmgdps:dp666
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