The iShares MSCI Emerging Markets ETF (EEM) demonstrates strong mean reversion trends, reversing 40% of its prior month’s returns. This creates opportunities for shorting and buying strategies.

Mean reversion refers to the tendency of an asset to reverse its previous return, and it is the opposite of trending behavior.

Currently, many instruments exhibit mean reversion on a monthly basis, such as SPY and QQQ, which, on average, reverse about 20% of their previous month's return.

One way to understand this phenomenon is through the strategy of buying on dips, which is based on the assumption that prices will revert to their mean.

A much stronger mean reversion is observed in EEM, the emerging markets ETF, which on average reverses 40% of the previous month's return. This is twice the pattern seen in the S&P 500.

EEM Monthly Return as a Function of Previous Month

Part of this behavior can be attributed to countries like Korea and Taiwan, which exhibit mean reversion, but to a lesser extent. The more significant reversion in EEM suggests that it is the overall trading of the ETF that is driving the pattern, rather than the performance of individual countries.

This mean reversion suggests that investors could profit by shorting EEM on its upward movements and buying on its downward movements, either as a standalone strategy or as part of a broader strategy.

We observe that many investors seem to be following this or a similar strategy.

The short position in EEM also demonstrates mean reversion, with the ETF typically decreasing after a positive month and increasing after a negative month.

A closer look at the graphs of the short position and the ETF reveals a very similar pattern: investors tend to short on the way up and cover on the way down.

EEM Stock Price and Short Position as % of Float