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A short-term reversal strategy exploits the strong tendency of stocks with strong gains and stocks with strong losses to reverse in a short-term time frame up to one month.
The strategy was well-known and academically studied, and appeared at first to be unprofitable because of its high trading frictions. The latest studies, however, show there is a significant edge on the big liquid stocks, which is possible to capture with reasonable trading costs.
Academics speculate that the fundamental reason for the anomaly is investors' overreaction to past information and a correction of that reaction after a short time horizon. The investment universe consists of the biggest companies by market capitalization. The investor goes long on the 10 stocks with the lowest performance in the previous month and goes short on the 10 stocks with the greatest performance from the previous month.
The portfolio is rebalanced weekly. Several studies report that abnormal returns associated with short-term reversal investment strategies diminish once transaction costs are taken into account. Limiting the stock universe to large cap stocks significantly reduces trading costs. Applying a more sophisticated portfolio construction algorithm to lower turnover reduces trading costs even further.
Our finding that reversal strategies can generate 30 to 50 basis points per week net of transaction costs poses a serious challenge to standard rational asset pricing models. Our findings also have important implications for the understanding and practical implementation of reversal strategies. Trading Costs of Asset Pricing Anomalies http: Using nearly a trillion dollars of live trading data from a large institutional money manager across 19 developed equity markets over the period to , we measure the real-world transactions costs and price impact function facing an arbitrageur and apply them to size, value, momentum, and short-term reversal strategies.
We find that actual trading costs are less than a tenth as large as, and therefore the potential scale of these strategies is more than an order of magnitude larger than, previous studies suggest. Furthermore, strategies designed to reduce transactions costs can increase net returns and capacity substantially, without incurring significant style drift. Results vary across styles, with value and momentum being more scalable than size, and short-term reversals being the most constrained by trading costs.
We conclude that the main anomalies to standard asset pricing models are robust, implementable, and sizeable. The returns of short-term reversal strategies in equity markets can be interpreted as a proxy for the returns from liquidity provision.
Using this a pproach, this article shows that the return from liquidity provision is highly predictable with the VIX index. Expected returns and conditional Sharpe ratios from liquidity provision spike during periods of financial market turmoil. The results point to withdrawal of liquidity supply, and an associated increase in the expected returns from liquidity provision, as a main driver behind the evaporation of liquidity during times of financial market turmoil, consistent with theories of liquidity provision by financially constrained intermediaries.
De Groot, Huij, Zhou: Our finding that reversal strategies generate 30 to 50 basis points per week net of transaction costs poses a serious challenge to standard rational asset pricing models. Upside and Downside Risks in Momentum Returns http: I provide a novel risk-based explanation for the profitability of momentum strategies. I show that the past winners and the past losers are differently exposed to the upside and downside market risks.
Winners systematically have higher relative downside market betas and lower relative upside market betas than losers. As a result, the winner-minus-loser momentum portfolios are exposed to extra downside market risk, but hedge against the upside market risk. Such asymmetry in the upside and downside risks is a mechanical consequence of rebalancing momentum portfolios.
But it is unattractive for an investor because both positive relative downside betas and negative relative upside betas carry positive risk premiums according to the Downside-Risk CAPM.
Hence, the high returns to momentum strategies are a mere compensation for their upside and downside risks. The Downside Risk-CAPM is a robust unifying explanation of returns to momentum portfolios, constructed for different geographical and asset markets, and it outperforms alternative multi-factor models. Log in Sign up. Notes to Confidence in anomaly's validity.