DP7068 An Institutional Theory of Momentum and Reversal
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.