An Institutional Theory of Momentum and Reversal

80 Pages Posted: 9 Dec 2008 Last revised: 8 Sep 2021

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. 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

Vayanos, Dimitri and Woolley, Paul, An Institutional Theory of Momentum and Reversal (December 2008). NBER Working Paper No. w14523, Available at SSRN: https://ssrn.com/abstract=1312619

Dimitri Vayanos (Contact Author)

London School of Economics ( email )

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Center for Economic Policy Research (CEPR)

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Paul Woolley

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

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