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Short-Term Residual Reversal

Last Updated on 10 February, 2024 by Rejaul Karim

Embarking on an innovative exploration of short-term reversal strategies, David Blitz, Joop Huij, Simon Lansdorp, and Marno Verbeek present “Short-Term Residual Reversal.” Unlike conventional approaches, their novel strategy, rooted in residual stock returns, avoids dynamic exposures to Fama and French factors, leading to risk-adjusted returns twice as substantial as traditional methods.

The research unveils statistically and economically significant profits, even in large-cap stocks post-1990, challenging prevailing notions that attribute reversal effects to trading frictions or non-synchronous trading.

This paradigm-shifting study challenges rational asset pricing models, offering a fresh perspective on short-term reversal dynamics that transcends conventional limitations, bringing forth a new era in financial exploration.

Abstract Of Paper

Conventional short-term reversal strategies exhibit dynamic exposures to the Fama and French (1993) factors. We develop a novel reversal strategy based on residual stock returns that does not exhibit these exposures and consequently earns risk-adjusted returns that are twice as large as those of a conventional reversal strategy. Residual reversal strategies generate statistically and economically significant profits net of trading costs, even when we restrict our sample to large-cap stocks over the post-1990 period. Our results are inconsistent with the notion that reversal effects are the result of trading frictions or non-synchronous trading of stocks and pose a serious challenge to rational asset pricing models.

Original paper – Download PDF

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Author

David Blitz
Robeco Quantitative Investments

Joop Huij
Erasmus University – Rotterdam School of Management; Robeco; Erasmus University Rotterdam (EUR) – Erasmus Research Institute of Management (ERIM)

Simon Lansdorp
Robeco Sustainable Index Solutions; Erasmus University Rotterdam (EUR) – Erasmus School of Economics (ESE); Tinbergen Institute

Marno Verbeek
Erasmus University – Rotterdam School of Management; Erasmus Research Institute of Management (ERIM); Netspar

Conclusion

In conclusion, this study unveils a novel paradigm in short-term reversal strategies by introducing a methodology grounded in residual stock returns. Unlike conventional strategies, our approach eliminates dynamic exposures to Fama and French factors, yielding risk-adjusted returns that are twice as substantial.

The statistical and economic significance of the profits, even when confined to large-cap stocks post-1990, challenges prevailing notions attributing reversal effects to trading frictions or non-synchronous trading.

The findings pose a formidable challenge to rational asset pricing models, suggesting a need for reevaluation in understanding the complexities of short-term reversal dynamics and paving the way for more robust investment strategies.

Related Reading:

Decomposing Short-Term Return Reversal

An Anatomy of Calendar Effects

FAQ

Q1: What sets the “Short-Term Residual Reversal” strategy apart from conventional short-term reversal approaches, and what are the key findings regarding risk-adjusted returns?
A1: The “Short-Term Residual Reversal” strategy distinguishes itself by being rooted in residual stock returns, avoiding dynamic exposures to Fama and French factors. Unlike traditional methods, this novel approach generates risk-adjusted returns twice as substantial, presenting a significant advancement in short-term reversal strategies.

Q2: How do the results of the study challenge existing notions about the drivers of reversal effects, and what specific factors do the findings contradict?
A2: The study challenges prevailing notions that attribute reversal effects to trading frictions or non-synchronous trading of stocks. The statistically and economically significant profits, even in large-cap stocks post-1990, contradict the idea that reversal effects are solely the result of these factors. The findings pose a serious challenge to rational asset pricing models.

Q3: What broader implications does the study suggest for understanding short-term reversal dynamics, and how might it influence future investment strategies?
A3: The study introduces a paradigm shift in understanding short-term reversal dynamics, suggesting a need for reevaluation. By eliminating dynamic exposures to traditional factors, the research opens the door to more robust investment strategies. The novel perspective provided by the “Short-Term Residual Reversal” strategy transcends conventional limitations, ushering in a new era in financial exploration.

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