Rational agents can upset asset-pricing paradigm

In contrast to the standard paradigm about momentum and reversal in markets being caused by agents reacting wrongly, new research shows that these phenomena can arise in markets with rational agents.

Dr Paul Woolley and Dr Dimitri Vayanos, are proposing a rational theory of momentum and reversal based on delegated portfolio management.

In research done for the Paul Woolley Centre for the Study of Capital Market Dysfunctionality, Woolley and Vayanos turn the standard asset-pricing paradigm on its head.

“Momentum and reversal are viewed as anomalies because they are hard to explain within the standard asset-pricing paradigm with rational agents and frictionless markets,” they say. Widespread explanations of these occurrences are behavioural, and assume that agents react incorrectly to information signals.

Woolley and Vayanos’ research shows that momentum and reversal “can arise in markets with rational agents”, and they abandon the standard paradigm by assuming that investors delegate the management of their portfolios to financial institutions, such as mutual funds and hedge funds.

Writing on “An Institutional Theory of Momentum and Reversal”, Woolley and Vayanos propose a rational theory say flows between investment funds are triggered by changes in fund managers’ efficiency, which investors see directly or infer from past performance.

“Momentum arises if fund flows exhibit inertia, and because rational prices do not fully adjust to reflect future flows,” they say. “Reversal arises because flows push prices away from fundamental values.”

Besides momentum and reversal, fund flows generate co-movement, lead-lag effects and amplification, with all effects being larger for assets with high idiosyncratic risk, while managers’ concern with commercial risk can make prices more volatile.

Ironically, managers’ efforts to protect themselves against commercial risk can have the perverse effect of making prices more volatile, and increase co-movement.

Woolley and Vayanos address the asset-pricing effect of commercial-risk management, that is of actions that managers can take to protect themselves against the risk of experiencing outflows.

“A manager concerned with commercial risk is reluctant to deviate from the market index,” they say. “The intuition in the case of asymmetric information is that a deviation subjects the manager to the risk of underperforming, relative to the market index and experiencing outflows.”

Commercial-risk concerns thus lower the prices of stocks that the active fund overweights, and raise those of underweighted stocks.