An Institutional Theory of Momentum and Reversal
London School of Economics; Center for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)
London School of Economics
August 2, 2010
AFA 2010 Atlanta Meetings Paper
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.
Number of Pages in PDF File: 79
Keywords: asset pricing, delegated portfolio management, momentum, reversal
JEL Classification: D5, D8, G1working papers series
Date posted: November 23, 2008 ; Last revised: August 10, 2010
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