Mean Reversion - potential to build investment strategy?

Mean Reversion refers to a tendency of asset prices to return to a trend path, typically with a half life of 3 to 5 years.

So on this basis, has anyone considered investing in out of favour sectors with the view they will outperform when they return to the typical trend path, and how do we identify the entry point - an underperformance over a certain percentage perhaps?

My first thought is ETFs such as INRG, down 35% in the past 3 years, yet VWRP which is up 22% but there may be better choices out there? Alternatively is the 35% drop on INRG due to a reversion back to norm in itself and we should stay clear?

1 Like

For a variety of reasons, I tend to focus on individual companies. However, I’m essentially happy to hold for the long term but will actively trade either to generate profit or to accumulate my holding (ie take the same cash value out of a trade = make no profit but leave the profit as long term share holding).

I recently bought Enphase in multiple accounts both as a trade and to take a long term position. I bought in the $80s but while I was hoping for a quick profit on the trade positions the long term stake I am less concerned about timescales but I will now actively trade it along the way.

I love finding what are hopefully undervalued shares. Whilst I focus on individual companies, over the last couple of months or so I’ve opened positions in several Trusts/Funds eg SMT which have good discount to NAV or have underperformed. In part that’s partly risk management (diversification) but also looking for a bargain.

I’m not sure how to read your second paragraph. If you are talking about an individual company I am generally cautious about a growth company going into a decline and will not automatically assume that it will resume the “trend path” in the future (unless we’re just considering a short term consolidation type pullback). If a share has gone into a downtrend lasting a year or more I tend to assume there’s a reason but potentially one that can end/reverse (eg if management changes or restructuring…).

I tend to read your second paragraph more as a reference to cyclical sectors eg resources or sectors such as banking or utilities/energy that can go out of favour for a while or be hit be some issue but will then recovery. I like those types of play. Often you can find fairly strong companies that just aren’t in favour - although always a risk there’s no such thing as a totally safe company.

In terms of your last paragraph, I think it may be easier to work out whether a decline/fall/drop is a correction (back to the norm/fair value) or an over-reaction or falling out of favour for individual companies than a fund. Also the comparison of INRG and VWRP isn’t a very fair one. VWRP is weighted to some mega cap companies that have had great performance and it surprising that VWRP performance in 2023 isn’t a lot better than it is. Thus I probably wouldn’t buy VWRP because I’d much prefer to take positions in the individual companies. However, if I thought INRG reflected a sector as a whole being out of favour (or facing a short term headwind) I might take a medium term position in it (until I felt that the sentiment to the sector was more balanced/fair) and take positions in individual companies that I felt were particularly undervalued. I wouldn’t compare sectors (ie tech to banking) I would generally consider them separately but recognise that hype about one sector (eg tech at the moment) might mean money exits sectors that are out-of-favour towards the trendy stuff (meaning some out-of-favour sectors could get devalued even more).

I’d be interested to hear views on entry points and how to spot them.

This is an interesting question, one I’ve been grappling with for the past couple of years.

I’ve been buying growth, small caps and private equity on this basis but I’m wary of being caught in a value-type trap.

I think you may have hit the nail on the head with INRG in that it could be a reversion to a mean of piss-poor performance.

Aside from a couple of years during the everything bubble, it’s been woeful.

According to Google, if you investing in INRG when it launched in 2007ish – you’d have lost more than half your money.

That’s a fair ol’ feat to lose investors’ money over such a relatively long period.

In its simplest form does this not also demonstrate the importance of long term investing to essentially balance out changes in performance. Personally I no longer have time to sit down and research my investment choices as much as I used to so can be quite lazy and just buy index tracking ETFs.

Yes exactly there needs to be enough data / parameters. You might like the below graph - if you opened a position when INRG had underperformed the FTSE all world by 70% - using VWRL as a proxy, you could have seen a nice return in around 18 months, more so if you held on to 2021.

@WakeMeUp - VWRL is purely chosen as a proxy baseline to the FTSE All World Index. I half have an idea to pick a series of long running themed or sector specific ETFs, and run analysis historically to see if there are identifiable trigger points to entry points of value. There is no guarantee in this process but I intend to consider it an experiment. 1Y, 3Y, 5Y potentially need to be reviewed to identify these markers, and not simply a reversion back to norm.