An Institutional Theory of Momentum and Reversal

76 Pages Posted: 18 Dec 2008

See all articles by Dimitri Vayanos

Dimitri Vayanos

London School of Economics; Center for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Paul Woolley

London School of Economics & Political Science (LSE)

Multiple version iconThere are 3 versions of this paper

Date Written: December 2008

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.

Keywords: delegated portfolio management, limits to arbitrage, momentum, reversal

JEL Classification: D5, D8, G1

Suggested Citation

Vayanos, Dimitri and Woolley, Paul, An Institutional Theory of Momentum and Reversal (December 2008). CEPR Discussion Paper No. DP7068. Available at SSRN: https://ssrn.com/abstract=1311191

Dimitri Vayanos (Contact Author)

London School of Economics ( email )

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Center for Economic Policy Research (CEPR)

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National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
United States

Paul Woolley

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom
44-20-7955-7477 (Phone)

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