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An institutional theory of momentum and reversal

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  • Vayanos, Dimitri
  • Woolley, Paul

Abstract

We propose a rational theory of momentum and reversal based on delegated portfolio management. Flows between investment funds are triggered by changes in fund managers’ efficiency, which investors either observe directly or infer from past performance. Momentum arises if fund flows exhibit inertia, and because rational prices do not fully adjust to reflect future flows. Reversal arises because flows push prices away from fundamental values. Besides momentum and reversal, fund flows generate comovement, lead-lag effects and amplification, with all effects being larger for assets with high idiosyncratic risk. Managers’ concern with commercial risk can make prices more volatile.

Suggested Citation

  • Vayanos, Dimitri & Woolley, Paul, 2011. "An institutional theory of momentum and reversal," LSE Research Online Documents on Economics 24423, London School of Economics and Political Science, LSE Library.
    • Handle: RePEc:ehl:lserod:24423
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    JEL classification:

    • E17 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Forecasting and Simulation: Models and Applications

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