Death, Taxes and Mean-Reversion

Waiting for Volatility

October 2017. Reading Time: 10 Minutes. Author: Nicolas Rabener.

Notice: This research note was originally published in October 2017 and was updated in May 2018 as the results changed slightly due to more accurate backtesting models. The update nearly exclusively impacted the charts and the conclusions remain the same as originally published.

SUMMARY

  • Mean-reversion has not performed well over the last few years
  • Highly sensitive to model assumptions
  • The strategy is an attractive addition for an equity-centric portfolio

INTRODUCTION

According to Benjamin Franklin death and taxes are the only two certainties in life. In finance, where much is uncertain, especially the future, mean-reversion might be considered a certainty. Mean-reversion can be defined in a variety of ways and applied to basically any variable. Economies that grow too quickly, often experience a downturn. Asset classes that reach excessive valuations, tend to correct. On stock markets we can differentiate between long-term and short-term mean-reversion. Value can be considered long-term mean-reversion as investors are buying stocks that have drifted downwards from a price and valuation perspective, speculating on a reversal. However, many investors also bet on short-term mean-reversion, e.g. when a favourite stock sold off too quickly from their perspective. In this short research note we will focus on short-term mean-reversion in the US stock market. We will analyse its performance, the intricacies of the strategy, and the use of the strategy for an equity-centric portfolio.

METHODOLOGY

Long-short mean-reversion portfolios are created by buying last week’s losers and selling last week’s winners. Portfolios are rebalanced on a weekly basis, making this a very high turnover strategy. The universe is defined as the top and bottom 2.5% of all US stocks with a market capitalization above $1bn. Per transaction 5bps are charged.

MEAN-REVERSION (LONG / SHORT) IN THE US

The chart below shows the mean-reversion strategy in the US from 2000 to 2017. We can observe an initial rise after the Tech bubble implosion in the 2000s, then a flat performance until the Global Financial Crisis, a large increase in the depth of the crisis, and thereafter mixed performance. Mean-reversion is a liquidity-providing strategy as it take