Working Paper: CEPR ID: DP7068
Authors: Dimitri Vayanos; Paul Woolley
Abstract: We propose a rational theory of momentum and reversal based on delegated portfolio management. A competitive investor can investthrough 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 heldby the active fund drop in anticipation of the investor's outflows, the drop is expected to continue, leading to momentum. Becauseoutflows push prices below fundamental values, expected returns eventually rise, leading to reversal. Fund flows generate comovementand 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 Codes: D5; D8; G1
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| negative cash flow shocks (G59) | outflows (F32) |
| outflows (F32) | price drops (D49) |
| negative cash flow shocks (G59) | price drops (D49) |
| price drops (D49) | momentum (C69) |
| price drops below fundamental values (D46) | expected returns rise (G17) |
| expected returns rise (G17) | reversal effect (G41) |
| momentum and reversal stronger for high idiosyncratic risk (G41) | manager's risk aversion (D81) |