Price reversal strategies, which buy stocks that have recently outperformed and short stocks that have recently underperformed, aren’t supposed to work. In an efficient market, prices reflect all available information and any investment based strictly on past performance shouldn’t be able to consistently outperform the market. But price reversal strategies do outperform, whether this is because they take advantage of investors’ non-rational tendency to overreact to new information or because price reversal strategies are getting a premium for supplying liquidity is an academic debate.
The more important issue is whether price reversal strategies, which involve rebalancing your portfolio monthly or even more often, can be improved to the point that they outperform net transaction fees.
Price reversal strategies can be improved by accounting for systematic factors
Citi analysts Andrew Lapthorne and Georgios Oikonomou have tackled this question with a method they call Residual Reversals method that takes a stock’s beta, 12 month volatility, and Fama/French benchmark factors all into account. They also constrain investments to a single sector instead of identifying winners and losers across the market, since this has improved performance in the past.
“There is a notable improvement in the back tested performance of the price reversal strategy when we account for systematic factors, particularly when adjusting for the Fama & French size and value factors. What is more, the past risk profile of the strategy is also considerably improved,” they write.
Lapthorne and Oikonomou also note that winners (stocks that outperformed last month) in the highest quintile of EPS growth continue to grow instead of correcting downward and losers with the weakest EPS growth correct upwards, but much less than other stocks. Cutting out these stocks with an EPS momentum overlay further improves the strategy.
Price reversal strategies are very sensitive to transaction costs
“Overall, the annualised back tested performance of our EPS overlay strategy has been 15.7% over the last 25 years, which compares to 11.8% for the conventional within-industry reversal strategy and just 6.2% for the across-market strategy. We also see a material improvement in the volatility of the strategy which drops to 8% versus more than 12% for the more conventional strategies. This amounts to more than double the increase in the risk-adjusted return of the strategy,” write Lapthorne and Oikonomou.
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Doubling the risk-adjusted return is impressive, but it actually might still not be enough to recommend the enhanced price reversal strategy which the analysts describe as “very sensitive to the level of transaction costs that one can achieve.”