Determining the Odds for Mean Reversion in Factor ETFs
Imagine standing at a bus stop waiting for the bus to arrive. If the schedule indicates that a bus arrives at your stop every 10 minutes or so, what is the probability of the bus arriving within the next eight minutes? In statistics, these types of questions are usually answered using an exponential distribution. What’s nice about this statistical tool is it provides a useful way to assign a probability associated with events that happen at certain frequencies — in our case the frequency of mean reversion for a factor.
Based on current trends and what we know about the average lengths of factors’ cycles, we can infer some interesting insights.
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Source: MSCI, CLS Investments. MSCI ACWI Factor Indices. As of 8/31/2016
For example, minimum volatility has outperformed the MSCI ACWI on a rolling 12-month basis for the last 22 months; that is nearly double the amount of time it is typically in or out of favor. This would suggest its statistical odds of seeing a reversion from current trends are fairly high. Similarly, value has underperformed on a rolling 12-month basis for the last 24 months; that is nearly the same amount of time associated with its cycle before mean reversion occurs. The statistical odds for this mean reversion are not as high as they are for minimum volatility, but they move higher the longer this trend persists.
Timing Factor ETFs is a Game of Patience
So, what is the key takeaway here? Timing factor ETFs is not as quick-paced or action-packed as most investors would like to believe. Why? Factor-based strategies tend to hone in on one or more factors with behavioral components that cause persistence for an extended period of time. As a result, they exhibit cycles with mean reversion tendencies that may be longer than most investors will wait to play out. Current trends in some factors suggest increased odds for mean reversion at some point down the road. However, as with all things in life, investors should remember that when it comes to factor investing, anything is possible.
Joe Smith, CFA, is a Senior Market Strategist at CLS Investments, a participant in the ETF Strategist Channel.
Disclosure Information
This information is prepared for general information only. Information contained herein is derived from sources we believe to be reliable, however, we do not represent that this information is complete or accurate and it should not be relied upon as such. All opinions expressed herein are subject to change without notice. The graphs and charts contained in this work are for informational purposes only. No graph or chart should be regarded as a guide to investing. 2434-CLS-9/21/2016.