Tactical Mean-Reversion

Hedging Tail Risks of Equity Portfolios Efficiently

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

SUMMARY

  • The Mean-Reversion factor is driven by volatility
  • Allocating tactically when volatility is high generates an attractive payoff profile
  • The strategy can be considered as a tail risk hedge for equity portfolios

INTRODUCTION

Our most recent research note focused on the Mean-Reversion factor (please see the report Mean-Reversion Across Markets), which highlighted performance and strategy characteristics. We noted that the strategy is attractive as a diversifier for equity portfolios; however, is difficult to hold given positive skewness, which implies long periods of flat or declining returns with infrequent, but significant positive returns. In this research note we will explore allocating tactically versus strategically in the context of viewing Mean-Reversion as a hedge against equity tail risks.

METHODOLOGY

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

MEAN-REVERSION AND VOLATILITY

Mean-Reversion is the inverse of short-term Momentum as the strategy consists of buying the worst performing and selling the best performing stocks, measured over very short time frames. These stocks have significantly under- or outperformed the market, which is due to stock-specific news. When volatility is low, then markets are likely to reflect news accurately; however, when volatility is high, then mispricings occur more frequently. The Mean-Reversion factor represents a liquidity-providing strategy and the compensation for providing liquidity is highest when markets are in turmoil and investors panic. The chart below compares the performance of the Mean-Reversion factor in the US to the VIX and highlights that more than 50% of the returns can be attributed to