This article is Part Three of our ‘Investing – An Alternative Approach’ miniseries. The series aims to inform readers about how the Frame Long Short Australian Equity Fund generates returns for its investors.
There are a variety of systematic investing strategies available to participants in financial markets. This article will specifically cover momentum investing and mean reversion trading. We also explore how they are implemented.
The Basics of Momentum Investing
The principals behind momentum investing are relatively simple. We want to be fully invested when the market is rising (so we can participate in upward momentum) and sitting on the sidelines during sustained periods of weakness in the market (so we avoid downwards momentum). While this sounds obvious, we should explore why this approach works. We turn to Newton’s first law: An object in motion will stay in motion unless acted on by an external force. Yes, that is physics, but the law seems to apply to stock prices as well, something Nick Radge explores in his book Unholy Grails (2012). He tested the profitability of two different strategies:
- Buy all current and delisted stocks on the ASX as they made a new yearly high.
- Buy all current and delisted stocks on the ASX as they made a new yearly low.
He tracked the profitability of each strategy after holding for n days. Radge found you would have a 51% probability of loss after 300 days if you bought a stock as it made a new yearly low. When buying a new yearly high however, you would have only a 37% chance of loss after 300 days!* It therefore seems a stock in motion stays in motion.
Despite the simplicity of the test, it indicates the principles behind momentum investing are sound.
The Basics of Mean Reversion Trading
Mean reversion trading is based on the idea that asset prices and volatility will converge to a long-term average (or mean). To profit from this idea, we are therefore looking to buy stocks that are trading below their perceived fair value, while selling stocks that are trading above their fair value. Again, this seems very simple, but how do we put it into action?
Many long term ‘value’ investors can actually be thought of as mean reversion traders. They determine the intrinsic (fair) value of a company through various techniques, buying those whose market price is below their calculated value. They will only sell once the company’s value has reached their target (in other words once it has ‘mean-reverted’). Warren Buffett would be the most well-known example of this approach to investing.
There is another way to trade reversion to a mean however. Academic consensus is that stock prices are best modelled with a form of stochastic process known as a geometric random walk. As you may have guessed, this implies the movement of stock prices are mostly random and that they do not mean revert. Luckily, we can find baskets of stocks that will mean revert when held in the correct proportions. One such strategy is known as pairs trading – you find two related stocks, trading one long and one short when their prices diverge more than expected.
There is obviously a significant amount of mathematics, statistics and research involved, so going from idea to implementation requires extensive testing.
While it is possible for retail investors to employ a systematic approach in their personal portfolios, time, data and capability constraints can make it difficult.
Before we begin trading a new systematic strategy, we undertake several rounds of testing to prove the strategy is robust. We start with basic testing to see how the strategy would have performed historically in terms of return and risk. If its performance meets our criteria, we then move on to higher level analysis. This includes stress testing (to see how it performs in weak markets), Monte Carlo simulations (to confirm statistical significance) and an analysis of how the returns and risk correlate with our current strategies. If a strategy passes all these hurdles we will introduce it into the portfolio, making sure our risk management practices are in place before we start trading it.
Part Four will cover discretionary investing techniques and how they can be integrated with systematic strategies to hedge, add alpha and smooth the portfolio’s return profile.
*Unholy Grails (2012) by Nick Radge, pgs. 3-4.