ARE PAIRS TRADING PROFITS ROBUST TO TRADING COSTS?

Authors


  • We are greatly appreciative to the following people for their advice on various aspects of this paper—most notably, regarding the thorny issue of constructing reliable proxies for trading costs applicable to institutional investors: Henk Berkman, Stephen Brown, Carole Commerton-Forde, Ray da Silva-Rosa, Doug Foster, Bruce Grundy, Allaudeen Hameed, Bing Liang, Lasse Pedersen, Tom Smith, Gary Twite, and Terry Walter. We are also thankful for advice from Leigh Sneddon, Managing Director, Blackrock, and Clare Rowsell, Head of Client Relationship Management, ITG Asia Pacific. We also benefit greatly from many helpful comments and suggestions from an anonymous referee.

Abstract

We examine the impact of trading costs on pairs trading profitability in the U.S. equity market, 1963 to 2009. After controlling for commissions, market impact, and short selling fees, pairs trading remains profitable, albeit at much more modest levels. Specifically, we document a risk-adjusted return of about 30 basis points per month among portfolios of well-matched pairs that are formed within refined industry groups. Pairs trading exhibits a lower risk and lower return profile than a short-term reversal strategy that sorts stocks relative to their industry peers. Notably, both these types of contrarian investing are largely unprofitable after 2002.

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