An Institutional Theory of Momentum and Reversal

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.

Firm Performance in the Context of Knowledge Based Intensive Sector: A Theoretical Review

“…It is worth noting that the concepts of institution and institutionalization have been viewed in diverse ways, which differ significantly (Vayanos & Woolley, 2013). The relationship between institutions and interest groups show that institutional features of organizational environments shape both the goals and means of actors.…”

Behavioral Finance: History and Foundations

“…Later, Barberis and Shleifer (2003) show how a trader who switches between different trading styles depending on their relative performance can cause stock price over-and underreaction. More recently, Vayanos and Woolley (2013) extended the idea of Barberis and Shleifer and proposed that mutual fund flows can explain momentum and reversals and make both strategies profitable to exploit.…”

Delegated portfolio management, optimal fee contracts, and asset prices

“…across time, normally distributed with mean δ > 0 and variance σ 2 > 0. The stock is traded in the 3 It is standard in the literature to assume an exogenous, constant riskless rate in models with CARA-normal assetpricing models (see, for example, Wang, 1993;Spiegel, 1998;Watanabe, 2008;Banerjee, 2011, andVayanos andWoolley, 2013). Moreover, Sundaresan (1983) provides a justification for a constant interest rate in a general equilibrium model with CARA agents.…”

“…This paper relates to the growing literature that discusses equilibrium implications of delegated portfolio management (Allen and Gorton, 1993;Shleifer and Vishny, 1997;Vayanos, 2004;Malliaris and Yan, 2012;Basak and Pavlova, 2013;Vayanos and Woolley, 2013;Sato, 2014). The following papers especially relate to this paper.…”