Pairs trading: is it applicable to exchange-traded funds?

Abstract

Among the various statistical trading strategies, pairs trading has been widely employed as a market neutral strategy owing to its simple approach and ease of application. In this context, we develop a cointegration-based pairs trading framework with a set of pre-conditions for pair eligibility and apply it to different asset classes. The performance analysis of a portfolio of 45 pairs is considered for the period of January 2007 to January 2021, which covers the period of a full market cycle of adjacent bull and bear periods; it is studied and benchmarked against the S&P500 index, which is considered as a proxy for the general market. We find an average annual return of 15% with an average Sharpe ratio of 1.43 after considering the transaction costs; we observe that this performance does not vary significantly with a change in the transaction cost levels and does not pass below the risk-free return levels with changing market conditions. Further, the strategy is observed to perform better during bear market conditions. Considering the highly liquid trading environment of the strategy, our findings raise a call for a discussion on the semi-strong form market efficiency.

Keywords

• Pairs trading
• Cointegration
• Quantitative strategies
• Exchange traded fund market