We've received some great questions about our overbought/oversold indicators (please keep them coming!). One that I wanted to discuss this week is: "Why is it that when a factor is `Oversold`, we don't always see a major decrease in the return for that factor as it reverts?" In other words, sometimes we highlight a factor as Oversold when in reality its cumulative returns are not actually declining.
Using Momentum as a recent example...below we can see that for the past three months, cumulative return for Momentum was up, then somewhat flat through the middle of the period, then actually went up a bit. On a normalized basis, however, returns were on the decline for much of that same time and the factor was flagged as Oversold.
To answer this question, let's briefly pull the lens back and talk about the concept of positive vs. negative risk premia. The notion that certain factors carry long term positive and negative trends is widely cited in academic and financial literature. In the table below, you can see the theory behind this directional trend for a few of the most pertinent factors:
(This slide may look familiar to you, as it's from our Learn2Quant 2017 talk. You can find the link to the full presentation HERE).
If we take a look at the 10-year charts for Momentum, Size, and Profitability in the US market, we can see these trends clearly borne out:
Medium-Term Momentum (05/17/2008 - 05/17/2018)
Note how the positive trend is positive over time, punctuated by a few sizable momentum crashes.
Profitability (05/17/2008 - 05/17/2018)
Remember, Profitability = Quality in our model, and there's a major positive long-term trend for Quality in the market.
Size (05/17/2008 - 05/17/2018)
Size, on the other hand, has a clear negative trend, peppered with a few positive "spikes."
So why care about short-term factor return trends at all?
Through the historical lens, when return suddenly reverts or moves away from the typical factor premia, we recognize these times as opportunities to scoop up the long-term risk premia at a discount. This is why it's important to follow these factors - you can avoid excess short term risks while identifying good factor "value."
Ultimately, we find it vital to couple an understanding of the short-term impact of factor returns and reversions with the long-term trend. If you'd like to see the impact of any of these on your portfolio's performance and risk profile, or would like to better understand how we measure the relationships between factors, please don't hesitate to reach out.
PS - Click here if you'd like to learn more about factor trends