Saturday, February 22, 2020

Mean reversion in style factors - Don't go chasing returns



"Don't chase those returns." "Follow what is best." There is aways contradictory advice with investments because returns are time varying and usually mean-revert. This applies to style factors as well as traditional betas. 

A simple analysis from MFS analyst Noah Rumpf in his study "Value, Momentum and Mean Reversion in Factor Returns" provides some useful insights on mean-reversion and style factors. Using the Fama-French database of 13 different style factors, Rumpf finds strong mean reversion. He uses a  simple sort of choosing the best factors and then looks at the forward performance.

If you pick a portfolio of the best four factor returns over the last 10-years, it will be the worst performing portfolio over the next year. The worst four factors will outperform the best over the next year. The classic idea of tracking returns and finding the best past performance will only result in financial heartache. Choosing the worst will have a better chance for success. 

The simplest solution to the mean reversion problem is to choose a diversified portfolio of good and bad factors. The bad ones are likely to be the least correlated with the good factors. Think about the environment and not the past performance. 

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