Value and Momentum Investing — our two favorite factors. We talk about these phenomena on our blog all the time, and have given both rational ⁽¹⁾ and behavioral explanations as to why these may occur. (Here is a hot off the press working paper that attempts the “rational” route).
However, only a handful of investors in the finance community directly invest in stocks with value and/or momentum characteristics — the individual stocks (or bonds) themselves. Instead, many use ETFs or mutual funds to gain access to these factors. Institutions generally do the same, either investing in hedge funds or managed accounts. This is delegated asset management, whereby one delegates the decision of the security selection onto a third-party manager. A by-product of delegation is that from time to time, the third-party manager must be assessed.

While many may claim the investment process is most important, performance is always taken into consideration, and often leads the decision-making process.

So what happens to a fund manager who is overweight the wrong industry? While the manager may be following their stated process, the ex-post assessment may be that the manager needs to be fired due to short-term underperformance. The manager needs to sell these securities. This puts pressure on stock prices they hold. Similarly, if a manager is doing well, they’ll end up owning momentum stocks, almost by construction. This manager will get more capital that will presumably be put in these same momentum stocks, thus driving these stock prices higher. Long story short, fund flows may lead to various momentum and reversal effects and delegated asset management could drive factors. But the devil is in the details and things can get complicated very quickly.

The goal of the paper, “An Institutional Theory of Momentum and Reversal,” by Vayanos and Woolley (2013), is to see how fund flows can create value and momentum effects in a world with rational agents. (see Barberis and Shleifer for the behavioral explanation). The authors look to develop a theory around how delegated asset management impacts value and momentum investing based on the flows between investment funds. To be clear, this is a theory paper, there is no data analysis.⁽²⁾

Some related articles we have written on this topic are from the perspective of the investor return gap, performance chasing, and past performance analysis.

Below we discuss some of the takeaways from the theory.

The Theory

The main goal of the theory is summarized in one sentence from the paper:

In this paper we show that momentum and reversal can result from flows between investment funds in markets where fund investors and managers are rational.

The theory paper in section 2 is set up by describing two investment options: (1) the market portfolio or the passive fund and (2) the active fund.

Takeaways assuming symmetric information on the cost of holding the fund:

Momentum and reversal arise even under symmetric information. For example, following an increase in the cost, the investor flows out of the active and into the index fund, effectively selling stocks that the active fund overweights relative to the index. Because flows are gradual, the bird-in-the-hand effect implies that the price of these stocks declines gradually, yielding momentum. Flows also generate comovement and lead-lag effects, i.e., cross-asset predictability. Since, for example, outflows from the active fund lower the prices of stocks that it overweights and raise those that it underweights, they increase comovement within each group while reducing comovement across groups. Moreover, since a price drop of an overweighted stock is correlated with outflows, it forecasts low expected returns of other overweighted stocks in the short run and high returns in the long run.

Now after adding asymmetric information:

The key new feature of asymmetric information is that fund flows not only cause stock returns, as under symmetric information, but are also caused by them. For example, a negative cashflow shock to a stock that the active fund overweights lowers the active fund’s performance relative to the index fund. The investor then infers that the cost has increased and flows out of the active and into the index fund. This lowers the stock’s price, amplifying the effect of the original shock. Amplification generates new channels of momentum, reversal and comovement. For example, momentum and reversal arise conditional not only on past returns, as under symmetric information, but also on past cashflow shocks. Moreover, a new channel of comovement is that a cashflow shock to one stock induces fund flows which affect the prices of other stocks.

Momentum, reversal, lead-lag effects and comovement are larger for stocks with high idiosyncratic risk. This result holds under both symmetric and asymmetric information, with the intuition being different in the two cases. For example, in the case of asymmetric information, a cashflow shock to a stock with high idiosyncratic risk generates a large discrepancy between the performance of the active and of the index fund. This causes large fund flows and price effects.

This model is close to the Barberis and Shleifer (BS 2003) model:

They assume that stocks belong to styles and are traded between switchers and fundamental investors. Following a stock’s bad performance, switchers assume that the corresponding style will perform poorly in the future, and switch to other styles. Switching is assumed to be gradual, and leads to momentum because fundamental investors are assumed not to anticipate the switchers’ predictable flows. Switching also generates comovement of stocks within a style, lead-lag effects, and amplification. We show that these effects can be consistent with rational behavior. We also study the effects of idiosyncratic risk and career concerns, neither of which is examined in BS.

Main Takeaway

This is a theory paper that incorporates the realities of delegated asset management to help explain why we would see momentum and reversals in asset prices. The main takeaway from the model is that momentum and reversal (i.e. value and momentum investing) can be caused by delegated asset management through the flow of funds.

An Institutional Theory of Momentum and Reversal

• Vayanos and Woolley
• A version of the paper can be found here.
• Want a summary of academic papers with alpha? Check out our Academic Research Recap Category.

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.