We continue last week’s introduction to the Reversal factors found in the Barra US Total Market Equity Trading Model and discuss how these factors can be useful in helping guide trading. Although the risk model has 3 flavors of reversion, we will focus on the two most relevant to fundamentally oriented and longer horizon investors: Short-Term Reversal (“STR”) and Long-Term Reversal (“LTR”). For a refresher on these factors and their characteristics, please revisit last week’s post.Last week, we observed the long-term trends in these factor returns: Since 2008, Short-Term Reversal has outperformed the market by +3.5%/annum and Long-Term Reversal has underperformed the market by -0.7%/annum. Accordingly, having a positive exposure to Short-Term Reversal names and a negative exposure to Long-Term Reversal names will help portfolio returns and having a negative exposure to Short-Term Reversal and a positive exposure to Long-Term Reversal will hurt portfolio returns.
Designing Mean Reversion Portfolios
We start by building a basic filter to define our local universe for the most liquid and tradeable names in the US, roughly equivalent to the Russell 3000. The cap-weighted universe has an average of 2,814 names and roughly a 2.5% tracking error to the Russell 3000, until the tracking error exploded during the COVID crisis. We then further filter this investible universe down to two groups depending on the Short-Term Reversal and Long-Term Reversal exposures:
“neg” refers to assets with unfavorable exposures: negative to STR and positive to LTR.
Examining Mean Reversion Portfolios
Below we confirm that our portfolios have the desired exposures to LTR:
Below we confirm that our portfolios have the desired exposures to STR:
This chart illustrates how quickly the Short-Term Reversal switches signs relative to the Long-Term Reversal factor. The Short-Term Reversal factor moves quickly, which induces turnover and transaction costs. As discussed last week, this variation of Short-Term Reversal “washes” out in the long term for long horizon investors.
How have these portfolios performed?
In both the “mcap” and “factor” weighting the POS portfolios outperform their respective NEG portfolios by ~8.5%/annum. This is obviously a very strong signal, and reinforces how quant flows have become a strong component of the market.
We run this experiment to illustrate the general market trend of how Reversal Factors behave. A Fundamental stock picker would never build a portfolio in this manner - it’s much more of a Quantitative Manager’s approach. But, we can at least highlight assets that have favorable trends and help managers decide buy and sell timing on names they have researched and either want to buy, or sell out of.
US & Global Market Summary
US Market: 5/18/20 - 5/22/20
Factor Update: Axioma Worldwide Equity Risk Model (AXWW4-MH)
Please let us know if you’d like to better understand and manage your exposure to any of the factors that we’ve discussed.