Do Mean Reverting based trading strategies outperform Buy and Hold?
If prices of assets are not aligned to their net present value, a trading strategy may be implemented when actual prices revert to fundamentals. This hypothesis is informally tested in real-time using a trading strategy which consists of identifying whether the equity index is over or under- priced. The fundamental price is constructed in real time using the net present value approach which requires the series for expected dividends, expected returns and expected dividend growth rate. These series, typi- cally unobservable, are derived from a structural state space model and econometric models. The performance of the rules depend on the fre- quency of the data. Cyclical behaviour within the the one year frequency may not be discarded. The trading strategy performs poorly implying that mean reversion may not be uncovered in real-time. However a hybrid variant of the structural and econometric model is shown to outperform the passive Buy and Hold strategy.
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