Mean-Reversion Across Markets

Hedging Tail Risks of Equity Portfolios

May 2018. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • The Mean-Reversion factor shows the same trends across markets
  • The strategy differentiates itself from other factors by exhibiting strong positive skewness
  • Mean-Reversion is an attractive diversifier for an equity-centric portfolio

INTRODUCTION

Volatility spiked in the first quarter of 2018 when global stock markets declined, which was mainly due to concerns on proposed tariffs by the US government and rising interest rates. Since then markets recovered and volatility declined again, but higher interest rates are likely to have a negative impact on the global economy given record levels of public, corporate and consumer debt. Higher rates probably result in lower corporate earnings and decreased consumer spending, which would lead to markets performing less well than in recent years and volatility to increase. Although this scenario would be a concern for most investors with traditional equity-bond portfolios, there are some strategies like Mean-Reversion that benefit from higher levels of volatility. In this short research note we will analyse the performance and characteristics of the Mean-Reversion factor and its potential utilisation in an equity-centric portfolio (read Death, Taxes and Mean-Reversion).

METHODOLOGY

We focus on the Mean-Reversion factor in the US, Europe and Japan. The factor is created via dollar-neutral long-short portfolios buying stocks with the worst weekly returns and shorting stocks with the highest weekly returns. The portfolios are created daily and rebalanced weekly, which results in a strategy with an exceptionally high turnover. In the US the top and bottom 2.5% of the stock universe are selected for the portfolio construction compared to the top and bottom 5% in Europe and Japan. Only stocks with a market capitalisation of larger than $1 billion are included. Transaction costs of 5 basis points are assumed for the US and 10 basis points for Europe and Japan.

MEAN-REVERSION ACROSS REGIONS

The chart below shows the performance of the Mean-Reversion factor in the US, Europe, Japan and globally, which equally allocates to these three markets, from 2000 to 2018. Overall the profiles are quite similar, which highlights that