Mean Reversion Effect in Country Equity Indexes

The mean reversion (value) anomaly is one of the oldest anomalies described by academia. It was originally discovered between stocks in one country but more and more academic studies shows it also works on country equity indexes, and its performance shows strong persistence. There are countless ways to exploit this anomaly, one very simple trading strategy was presented for example in work by Richards (1997).

Fundamental reason

One interpretation of the result is that reversals are the result of cross border equity flows being insufficiently large to remove mispricing, perhaps due to investors’ fears of expropratiation or capital controls. Another explanation is behavioral biases present in investors' behavior.

Markets traded
Confidence in anomaly's validity
Notes to Confidence in anomaly's validity
Period of rebalancing
3 Years
Notes to Period of rebalancing
Number of traded instruments
Notes to Number of traded instruments
in a sample study, it depends on investor's need for diversification
Complexity evaluation
Simple strategy
Notes to Complexity evaluation
Financial instruments
ETFs, funds
Backtest period from source paper
Indicative performance
Notes to Indicative performance
per annum, performance from Table 1 Panel B for holding period 36 months
Estimated volatility
not stated
Notes to Estimated volatility
Maximum drawdown
not stated
Notes to Maximum drawdown
Sharpe Ratio
not stated


reversal, rotational system, country picking

Simple trading strategy

The investment universe consists of 16 ETFs (funds) which invest in individual countries equity indexes. Go long on the bottom 4 countries with the worst 36 - month return and go short on the top 4 countries with best 36-month return. Rebalance every 3 years.

Source Paper

Richards: Winner-Loser Reversals in National Stock Market Indices: Can They be Explained?
This paper examines possible explanations for "winner-loser reversals" in the national stock market indices of 16 countries. There is no evidence that loser countries are riskier than winner countries either in terms of standard deviations, covariance with the world market or other risk factors, or performance in adverse economic states of the world. While there is evidence that small markets are subject to larger reversals than large markets, perhaps because of some form of market imperfection, the reversals are not just a small-market phenomenon. The apparent anomaly of winner-loser reversals in national market indices therefore remains unresolved.

Other Papers

Balvers, Wu: Momentum and mean reversion across national equity markets
Numerous studies have separately identified mean reversion and momentum. This paper considers these effects jointly. Our empirical model assumes that only global equity price index shocks can have permanent components. This is motivated in a production-based asset pricing context, given that production levels converge across developed countries. Combination momentum-contrarian strategies, used to select from among 18 developed equity markets at a monthly frequency, outperform both pure momentum and pure contrarian strategies. The results continue to hold after corrections for factor sensitivities and transaction costs. They reveal the importance of controlling for mean reversion in exploiting momentum and vice versa.

Balvers, Wu, Gilliland: Stock Markets and Parametric Contrarian Investment Strategies
For U.S. stock prices, evidence of mean reversion over long horizons is mixed, possibly due to lack of a reliable long time series. Using additional cross-sectional power gained from national stock index data of 18 countries during the period 1969 to 1996, we find strong evidence of mean reversion in relative stock index prices. Our findings imply a significantly positive speed of reversion with a halflife of three to three and one-half years. This result is robust to alternative specifications and data. Parametric contrarian investment strategies that fully exploit mean reversion across national indexes outperform buy-and-hold and standard contrarian strategies.

Spierdijk, Bikker, Van den Hoek: Mean Reversion in International Stock Markets: An Empirical Analysis of the 20th Century
This paper analyzes mean reversion in international stock markets during the period 1900-2008, using annual data. Our panel of stock indexes in seventeen developed countries, covering a time span of more than a century, allows us to analyze in detail the dynamics of the mean-reversion process. In the period 1900-2008 it takes stock prices about 13.8 years, on average, to absorb half of a shock. However, using a rolling-window approach we establish large fluctuations in the speed of mean reversion over time. The highest mean reversion speed is found for the period including the Great Depression and the start of World War II. Furthermore, the early years of the Cold War and the period covering the Oil Crisis of 1973, the Energy Crisis of 1979 and Black Monday in 1987 are also characterized by relatively fast mean reversion. Overall, we document half-lives ranging from a minimum of 2.1 years to a maximum of 23.8 years. In a substantial number of time periods no significant mean reversion is found at all, which underlines the fact that the choice of data sample contributes substantially to the evidence in favour of mean reversion. Our results suggest that the speed at which stocks revert to their fundamental value is higher in periods of high economic uncertainty, caused by major economic and political events.

Smith, Pantilei: Do 'Dogs of the World' Bark or Bite? Evaluating a Mean-Reversion-Based Investment Strategy
Mean reversion in financial markets is commonly accepted as a powerful force. This paper examines the performance of a simple mean-reversion-based strategy -- Dogs of the World -- designed to take advantage of return reversals in national equity markets. Both a simulated application of the strategy using indexes since 1971 and application using single-country ETFs since 1997 produces higher compounded average returns than those of a comparable market index. Although the Dogs strategy also produces higher volatility than the index, the information ratio for the strategy suggests that the return more than compensates. An advantage of this strategy is that its implementation using single-country ETFs is straightforward and inexpensive.

Lakonishok, Schleifer, Vishny: Contrarian Investment Extrapolation and Risk
For many years, scholars and investment proffesionals have argued that value strategies outperform the market. These value strategies call for buying stocks that have low prices relative to earnings, dividends, book assets, or other measures of fundamental value. While there is some agreement that value strategies produce higher returns, the interpretation of why they do so is more controversial. This article provides evidence that value strategies yield higher returns because these strategies exploit the suboptimal behavior of the typical investor and not because these strategies are fundamentally riskier.

Zaremba: Combining Equity Country Selection Strategies
The recent rise of passive investment products granted investors easy access to international markets. The basic motivations of this paper is to offer investors new tools to allocate assets across countries. The study investigates the performance of equity country selection strategies based on combinations of theoretically and empirically motivated variables. Thus, we form portfolios and assess their performance with asset pricing models. The empirical examination is based on data from 78 within the period from 1999 to 2015. The strategies based on earnings-to-price ratio, turnover ratio and skewness prove useful tools for international investors. Furthermore, portfolios from sorts on blended rankings of skewness combined with earnings-to-price ratio or turnover ratio are also characterized by attractive risk-return relation. However, the joint strategies do not outperform the strategies based on single metrics. As a result, we argue that given the low correlations among the returns on single-variable strategies investors would be better off building a diversified portfolio of them than combining them into one strategy.

Gharaibeh: Long-Term Contrarian Profits in the Middle East Market Indices
This paper examines whether there is an existence of a long-term contrarian profits at the Middle East (ME) market indices. This paper shows strong evidence for the long-term contrarian strategy in the Middle East indices. The result of this study demonstrates that the long-term contrarian profits for the Middle East markets can’t be explained by two-factor model. In spite of whether winners are smaller or larger than losers, there are long-term abnormal profits. Finally, the findings in this paper suggest that the long-term contrarian profits may be stronger and more enveloping than is usually understood.