Saturday, October 06, 2007

How a mean-reversion strategy performed in August

Prof. Andrew Lo and Mr. Amir Khandani at MIT recently wrote a paper on "What Happened To The Quants In August 2007?" (Hat tip to my reader Mr. J. Rigg for the article). Most of their conclusions confirm what many observers already suspected: that the loss is likely due to the simultaneous forced liquidation of portfolios holding similar positions by various quantitative funds. What is noteworthy, however, is that they constructed a mean-reversion strategy and observed what happened to it during August. This strategy is very simple: buy the stocks with the worst previous 1-day returns, and short the ones with the best previous 1-day returns. Despite its utter simplicity, this strategy has had great performance since 1995, ignoring transaction costs. The Sharpe ratio was an astounding 53.87 in 1995, gradually decreasing to 4.47 in 2006. However, the strategy also had a disastrous few days on August 7-9, suffering a cumulative (arithmetic) return of -6.85% in those 3 days. Then on August 10, it rebounded, like the rest of the quant funds, with a return of 5.92%, almost reversing all of its previous losses. For me, this experiment reveals three interesting points: 1) a simple price factor seems to capture most of the performance of the complex factor models run by the gigantic hedge funds; 2) even technical mean-reverting factors suffer losses, not just momentum (growth) factors based on fundamentals; and 3) if one wants to avoid disasters and enjoy spectacular returns, even a one-day holding period is too long. I haven't done the experiment myself yet, but I bet that if we were to liquidate the portfolio at market close each day, not only would we avoid the loss of -6.85% in those 3 days, but would probably end up with a positive return of a similar magnitude!

8 comments:

Anonymous said...

Dott.Chan this isa great blog that I read every time I can.
You often talk of intradaily sistems taht are the best and now again you write of close the trades daily.
Could you explane how you realize
a simple intraday trading sistem?
Statistical Mean reverting for ex.?
I read that the gains are made on overnight overall...

thanks!

Ernie Chan said...

Dear Anonymous,
An example intraday trading system is just as I described in this article -- a simple variation of Prof. Lo's mean-reverting strategy. Instead of updating the portfolio at each day's close and carrying the positions overnight, you can update the portfolio at each day's open and exit all the positions at the close.
Ernie

Anonymous said...

It's quite insteresting that the most simple models seems to be the most powerful. Most financial models have very simply forms. I also confirm this from my owe experience. At first I tried to design complex models to forecast price movements, but failed. Then I reduced factors to include only price: the model works very well now: it can be applied to every market (equity,currency,future,commodities).

johntrend@yahoo.ca

Ernie Chan said...

John,
That's exactly my experience too.
Ernie

Anonymous said...

I think your conclusions in this post are completely wrong... How do you justify them? The fact that some strategies make money before transactions costs does not mean that they explain strategies that make money after transaction costs!!

Ernie Chan said...

Dear Anonymous,

1) I think your argument is mainly with Prof. Lo. I simply paraphrased his conclusions.

2) Strategies that trade highly liquid stocks (such as the midcap stocks in Prof. Lo's study) at most twice a day (once, in Prof. Lo's study; twice, in my suggestion) do not suffer so much impact from transaction costs that would render them unprofitable. This is both from my own theoretical studies as well as actual trading experience.

3) The point of Prof. Lo's study is not the exact magnitude of the daily returns, which would of course be lowered by the introduction of transaction costs. The point is the sign of the returns, which as I argued above, is unlikely to be changed here.

Ernie

Anonymous said...

I had a done a similar thing but on the long term. I invested in the long term for companies who did well one day and companies who did poorly one day.



Over 1.5 years my returns were 50% and 13% respectively. That 13% would be wiped out by all the fees I would've had to pay. Where as that 50% would've been ok. I don't know the current valuation in the current economy.

Jing said...

Hi, I think mean-reversion system is paired with huge intraday drawdown and that can NOT be avoided. If you use a tight, fixed stop loss for mean-reversion, the performance will be dramatically reduced. For a trend following system, the stop loss can be tight as 1 ATR without affecting performance much. But for mean-reversion system, the stop loss need to be at least 3 times ATR or most of cases higher. I think the huge drawdown is the cost to have a high winning percentage and you can't get the best from both world.