Now, however, the pendulum seems to have swung a little too far in the other direction. Whenever I mention a high Sharpe-ratio strategy to some experienced investor, I am often confronted with dark musings of "picking up nickels in front of steamrollers", as if all high Sharpe-ratio strategies consist of shorting out-of-the-money call options.
But many high Sharpe-ratio strategies are not akin to shorting out-of-the-money calls. My favorite example is that of short-term mean-reverting strategies. These strategies not only provide consistent small gains under normal market conditions, but in contrast to shorting calls, they make out-size gains especially when disasters struck. Indeed, they give us the best of both worlds. (Proof? Just backtest any short-term mean-reverting strategies over 2008 data.) How can that be?
There are multiple reasons why short-term mean-reverting strategies have such delightful properties:
- Typically, we enter into positions only after the disaster has struck, not before.
- If you believe a certain market is mean-reverting, and your strategy buy low and sell high, then of course you will make much more money when the market is abnormally depressed.
- Even in the rare occasion when the market does not mean-revert after a disaster, the market is unlikely to go down much further during the short time period when we are holding the position.
So, call me old-fashioned, but I still love high Sharpe-ratio strategies.