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)