Mean Reversion Based on Autocorrelation: A Comparison Using the S&P 100 Constituent Stocks and the 100 Most

Liquid ETFs
May 2011

Authors: Christian L. Dunis Jason Laws Jozef Rudy

Corresponding author and presenter : Jozef Rudy J.Rudy@2009.ljmu.ac.uk Liverpool JMU, TATRA Asset Management

Outline
Motivation

Data used
2 types of data: daily and half-daily In- and out-of-sample periods

Methodology
2 types of portfolios from either pair of ETFs or shares Conditional parameters No optimization

Results
Comparison of results for ETF and share portfolios and daily, half-daily data

Conclusions
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Motivation
Contrarian profits explained by overreaction hypothesis (Lo and MacKinlay, 1990), where assumption of negative autocorrelation is very common (Locke and Gupta, 2009) Recent decreasing performance of contrarian strategies (Khandani and Lo, 2007)

According to Kim (2009), after accounting for statistical biases, contrarian strategies are not profitable at all
Majority of trading ideas well-known across Wall Street. A practical implementation and parameters make every strategy unique (Chan, 2009) Unique idea: to increase sampling frequency from Close-Close to Close-Open-Close and compare performance for ETFs and shares
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Data used
S&P 100 Equities and 100 most liquid ETFs:
Data Half-daily data : 2nd Jan 2002 26th Nov 2010 : 2nd Jan 2002 26th Nov 2010

Every day, pairs are formed from either 2 shares or 2 ETFs that fulfill 3 criteria described in Methodology
In- and Out-of-Sample Periods:

Methodology I
In every sessions, 2 portfolios of pairs are formed that contain either pairs of shares or ETFs with:
Conditional correlation over 0.8 Conditional autocorrelation in certain bounds

Normalized return over previous period higher than 1

Methodology II
Conditional correlation: where and
t
cov(rA , rB )t

tA tB

cov(rA , rB )t cov(rA , rB )t 1 (1 )rA rB

t

t21 (1 )r 2

, see JPMorgan (1996)

t
Rt

Normalized return:

rt

, where

Pt A Pt B Rt ln( A ) ln( B ) Pt 1 Pt 1

Methodology III
2 Portfolios from pairs of shares and ETFs, contain only 5 best pairs in any moment. Best pairs are 5 pairs with the highest normalized return, that fulfill before mentioned conditions None of the thresholds have been optimized, thus possibility to obtain even better results. However, in-sample optimization would take very long time

Methodology IV
Measure of profitability For daily data :
Annualized Information Ratio R

. 252

For half-daily data: Annualized Information Ratio R .

252*2

Costs of trading
Trading costs one-way for both shares (long and short): 0.2%
Transaction costs: 0.1% (0.05% * 2) Bid-ask spread: 0.1% (0.05% * 2)

Net return calculation:

Rett ln( PX t / PX t 1 ) ln( PYt / PYt 1 ) TC

Results daily data

Portfolio consisting of 5 best pairs of shares

in-sample results

out-of-sample results

Results daily data

Portfolio consisting of 5 best pairs of ETFs

in-sample results

out-of-sample results

Results half-daily data

Portfolio consisting of 5 best pairs of shares

in-sample results

out-of-sample results

Results half-daily data

Portfolio consisting of 5 best pairs of ETFs

in-sample results

out-of-sample results

Results half-daily data

Works with 10 Portfolio consisting of 10 best pairs of ETFs

out-of-sample results

Results half-daily data

and 20 as well Portfolio consisting of 20 best pairs of ETFs

out-of-sample results

Conclusions
Information ratios for ETF pairs are higher than for pairs of shares Half-daily sampling frequency provides better results than using a daily sampling frequency Spread returns of pairs with negative first-order autocorrelation are easier to predict than the returns of pairs with the same but positive autocorrelation

References
Alexander, C. and Dimitriu, A. (2002) The Cointegration Alpha: Enhanced Index Tracking and Long-Short Equity Market Neutral Strategies. SSRN eLibrary, http://ssrn.com/paper=315619 Burgess, A. N. (2003) Using Cointegration to Hedge and Trade International Equities. In Dunis, C., Laws, J. And Nam, P. [eds.] Applied Quantitative Methods for Trading and Investment. John Wiley & Sons, Chichester, 41-69. Chan, E. (2009) Quantitative Trading: How to Build Your Own Algorithmic Trading Business, John Wiley & Sons, Inc., New Jersey. Jpmorgan (1996) Riskmetrics, New York. Khandani, A. E. and Lo, A. W. (2007) What Happened to the Quants in August 2007? Journal of Investment Management, 5, 4, 5-54. Kim, H. (2009) On the Usefulness of the Contrarian Strategy across National Stock Markets: A Grid Bootstrap Analysis. Journal of Empirical Finance, 16, 5, 734-744. Lo, A. W. and Mackinlay, A. C. (1990) When Are Contrarian Profits Due to Stock Market Overreaction? The Review of Financial Studies, 3, 2, 175-205. Locke, S. and Gupta, K. (2009) Applicability of Contrarian Strategy in the Bombay Stock Exchange. Journal of Emerging Market Finance, 8, 2, 165-189.
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Thank you for your attention Q&A

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