Mean reversion strategies are easy to understand, but that doesn’t mean you can make money

Mean reversion strategies assume big moves will eventually reverse, at least in part. That’s in contrast to momentum strategies, which assume big moves will continue in the same direction for lengthy periods.

In mathematical terms, the financial concept of mean reversion is better known as “regression to the mean,” which refers to the likelihood of a deviated dataset reverting to the mean.

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In other words, you might flip a coin ten times and all ten flips result in heads. But if you were to do 5,000 or more coin flips, it would be extremely likely for the rate of heads occurrences to regress to nearly 50%.

As long-time readers know, we welcomed the arrival of ETFs (Exchange Traded Funds) when they came on the market as “the most benign stock market innovation we’ve seen since stock commissions became negotiable.”

However, the financial industry often figures out a way to offer investors attractive terms on a newly minted version of an innovation, just to get their interest. This is the “introductory bargain phase” of the innovation’s life. Eventually, the industry introduces an updated version that’s a little more beneficial to the industry and a little less generous to the clients. Later versions may still have some appeal, especially for investors with cash to invest and little time to consider the best place to do so.

Eventually the industry comes up with a version that you could compare to snatching loose change off the ground when it’s in the path of a bulldozer. This, though, is an extreme.

More often, the industry comes up with a middle-of-the-road version that will make money for both the industry and the client…most of the time. However, the industry will make some money pretty much every year, whereas the clients will have some bad years that wipe out most of their profits.

Meanwhile, the Hamilton Enhanced Canadian Bank ETF follows a mean-reversion strategy. At the same time, it has a high MER of 0.65%. It costs its holders money every quarter that it adjusts its holdings. That alone dampens our interest.

Here’s a closer look.

For example, the Hamilton Enhanced Canadian Bank ETF, aims to tracks the Solactive Canadian Bank Mean Reversion Index

This index invests in the biggest six Canadian banks—Bank of Nova Scotia, Bank of Montreal, CIBC, Royal Bank, TD and National Bank. The ETF’s MER is 0.65%—high for an ETF.

The Hamilton Enhanced Canadian Bak ETF believes that historical data shows the individual top-six Canadian banks have tended to perform similarly over time. This ETF aims to take advantage of that perceived tendency by rebalancing its portfolio quarterly. It then invests 80% of the portfolio in the three banks that have recently underperformed, and 20% in the three banks that have outperformed.

This strategy has led the ETF to currently hold the six banks in the following proportions: CIBC (17.5% of assets), National Bank (17.1%), Bank of Montreal (17.0%), Royal Bank (16.8%), TD (15.5%) and Bank of Nova Scotia (15.2%).

Mean reversion is an easy market concept to understand, but that doesn’t mean you’ll automatically or even consistently make money from it.

While prices may tend to revert to the mean over time, you can’t know in advance when this revision will happen. Prices can continue moving away from the mean for longer than you expected—months, years, even decades.

The mean reversion approach practiced by the Hamilton Enhanced Canadian Bank ETF incurs ongoing brokerage charges as it regularly rebalances its holdings. More important, the approach may also cause the fund to, for instance, buy more of a bank that has entered a long-term falling trend. It also forces the ETF to sell off holdings in banks that are rising steadily—perhaps missing out on extraordinary gains.

As part of our Successful Investor philosophy (which we also apply to the portfolios we manage for our clients through our affiliate, Successful Investor Wealth Management Inc.), we advise that a new addition to a portfolio should initially make up no more than 5% of the portfolio’s value.

But rather than automatically selling all or part of a bank stock that rises more than the other banks, we look at its underlying fundamentals (revenue, profits, cash flow, debt, and so on) to see if it still has room to rise. And in the same way, we don’t reflexively add to our holdings of underperformers—we take a closer look.

We now see all six Canadian banks as attractive long-term investments, but they do tend to leapfrog each other in performance and investment desirability. That’s why we advise most Canadians to invest in two or even three of them.

Our decision about recommending any one bank stock as a buy or sell depends, as mentioned, on the underlying fundamentals.

Our advice: Buy two or three bank stocks and hold them until you see a good reason to make changes. Their steady dividends will ease any pain of boredom.

Do you invest in these banks, or this ETF? Why or why not?