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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.

Suggested Citation

  • Dimitri Vayanos & Paul Woolley, 2008. "An Institutional Theory of Momentum and Reversal," NBER Working Papers 14523, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:14523
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    References listed on IDEAS

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    More about this item

    JEL classification:

    • D5 - Microeconomics - - General Equilibrium and Disequilibrium
    • D8 - Microeconomics - - Information, Knowledge, and Uncertainty
    • G1 - Financial Economics - - General Financial Markets

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