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Title: An Institutional Theory of Momentum and Reversal

Author(s): Dimitri Vayanos and Paul Woolley

Publication Date: December 2008

Keyword(s): delegated portfolio management, limits to arbitrage, momentum and reversal

Programme Area(s): Financial Economics

Abstract: 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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Bibliographic Reference

Vayanos, D and Woolley, P. 2008. 'An Institutional Theory of Momentum and Reversal'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=7068