Working Paper: NBER ID: w14523
Authors: Dimitri Vayanos; Paul Woolley
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.
Keywords: Momentum; Reversal; Delegated Portfolio Management; Fund Flows
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 shock to fundamental value (G19) | Outflows from active funds (G23) |
| Outflows from active funds (G23) | Price depreciation (E31) |
| Price depreciation (E31) | Momentum (C69) |
| Momentum (C69) | Prices drop below fundamental values (D46) |
| Expected returns rise (G19) | Price recovery (D44) |
| Fund flows (F21) | Comovement among stocks (C10) |
| Fund flows (F21) | Lead-lag effects among stocks (C69) |