A researcher has investigated the returns over the last five years to a long-short strategy based on mean reversion in equity returns volatility. His hypothesis led to rejection of the hypothesis that abnormal (risk adjusted) returns to the strategy over the period were less than or equal to zero at the 1% level of significance. He would most appropriately decide that:
A. His firm should employ the strategy for client accounts because the abnormal returns are positive and statistically significant.
B. while the abnormal returns are highly significant statistically, they may not be economically meaningful
C. as long as the estimated statistical returns are greater than the transactions costs of the stratefy, his firm should employ the stratefy for clients accounts
Neither I understood the question nor any of the choices. Can anyone explain this?
I will do my best to help you out. The question is saying that a person is testing the viability of going long and short in a portfolio of equities and the ability of that portfolio to generate abnormal risk adjusted returns.
Mean reversion says that over time returns on equities will revert back to its long term mean, at whatever interval and number was previously witnessed.
From the way it’s stated the null hypothesis is that mean returns <= 0%
The alternative hypothesis is that mean return is > 0%
At alpha = 1% or at the 99% confidence interval, his test statistic was large enough to reject the null hypothesis.
A) His firm should implement this strategy because the returns that can be generated with this strategy are highly positive and statistically significant. More positive and better than what the firm was previously using as their strategy.
B) The test did produce a statistically significant result (enough to reject the null hypothesis at the very conservative 1% alpha) but the returns generated in actuality would be negligible.
C) Same as B but that the firm should trade on the long short strategy if the net return generated after accounting for transaction costs of implementing the strategy is positive.
For me I would say the answer is B mainly because I believe not all clients would have suitability for the portfolio strategy and would have unique constraints. I could see the answer being C as well though. What does the given answer and explanation say?