Picking up nickels in front of steamrollers

When I was growing up in the trading world, high Sharpe ratio was the holy grail. People kept forgetting the possibility of "black swan" events, only recently popularized by Nassim Taleb, which can wipe out years of steady gains in one disastrous stroke. (For a fascinating interview of Taleb by the famous Malcolm Gladwell, see this old New Yorker article. It includes a contrast with Victor Niederhoffer's trading style, plus a rare close-up view of the painful daily operations of Taleb's hedge fund.)

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:

1. Typically, we enter into positions only after the disaster has struck, not before.
   
2. 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.
3. 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.

"Short-term" is indeed the key to the success of these strategies. In contrast to the LTCM debacle, where they would keep piling on to a losing position day after day hoping it would mean-revert some day, short-term traders liquidate their positions at the end of a fixed time period, whether they win or lose. This greatly limits the possibility of ruin and leaves our equity intact to fight another day in the statistical game.

So, call me old-fashioned, but I still love high Sharpe-ratio strategies.

In praise of ETF's

I have learned some years ago that ETF's are strange and wonderful creatures. Simple, long-only mean-reverting strategies that work very well on ETF's, won't work on their component stocks. (Check out a nice collection of these strategies in Larry Connors' book "High Probability ETF Trading". He has also packaged these strategies into a single indicator, the ETF Power Ratings, on tradingmarkets.com.) Simple pair trading strategies like the one I discussed in my book, also work much more poorly on stocks than on ETF's. Why is that?

Well, one obvious reason is that, as Larry mentioned in his book, ETF's are not likely to go bankrupt (with the notable exception of the triple-leveraged ETF's, as I explained previously), because a whole sector or country is not likely to go bankrupt. So you can pretty much count on mean-reversion if you are on the long side.

Another obvious reason is that though there are news which will affect the valuation of a whole sector or country, these aren't as frequent or as devastating as news affecting individual stocks. And believe me, news is the biggest enemy of mean-reversion.

But finally, I believe that the capital weightings of the component stocks also play a part in promoting mean-reversion. Typically, weighting of a component stock increases with its market capitalization, though not necessarily linearly. Perhaps large-cap stocks are more prone to mean-reversion than small-cap stocks? But more intriguingly, can we not construct a basket of stocks, with custom-designed weightings, with the objective of optimizing its short-term mean-reversion property? I (and others before me) have done something similar in constructing a basket of stocks that cointegrate best with an index. Can we not construct a basket that is simply stationary (with perhaps a constant drift)?

Now, perhaps you will agree with me that ETF's are strange and wonderful creatures.