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In this study the authors argue that the value and momentum effects may be the result of fund flows. They propose a model in which flows between investment funds are triggered by changes in fund managers’ efficiency, which investors either observe directly or infer from past performance.
They find that momentum arises if fund flows exhibit inertia, and because rational prices do not fully adjust to reflect future flows. A value (reversal) effect arises because flows push prices away from fundamental values.
Besides momentum and value effects, the model also predicts co-movement, lead-lag effects and amplification, with these being larger for high-idiosyncratic-risk assets. We like this study because it helps to rationalize the existence of the value and momentum effects, which are typically attributed to ‘irrational’ investor behavior.