An institutional Theory of Momentum and Reversal

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' e±ciency, which investors either observe directly or infer from past performance. Momentum arises if fund °ows exhibit inertia, and because rational prices do not fully adjust to re°ect future °ows. Reversal arises because °ows push prices away from fundamental values. Besides momentum and reversal, fund °ows generate comovement, lead-lag e®ects and ampli¯cation, with all e®ects being larger for assets with high idiosyncratic risk. Managers' concern with commercial risk can make prices more volatile.