Blog - Investing Notes

February 9, 2010 - ETF Pair Trading Based on Relative Returns/Volatilities (Updated 3/6/10 based on a revision to the paper)

Does pairs trading work for exchange-traded funds (ETF)? In their February 2010 paper entitled "Pairwise Asset Rotation Trading and Market Timing: An Anatomy to a New Trading Strategy", Panagiotis Schizas and Dimitrios Thomakos present a market timing strategy based on transforming the predictability of relative returns/volatilities between pairs of ETFs into weekly trading signals via simple rules. They choose S&P Depository Receipts (SPY), the Financial Sector Select SPDR (XLF), PowerShares QQQ (QQQQ) and Oil Services HOLDRs (OIH) to investigate three pairs: SPY-XLF, SPY-QQQQ and SPY-OIH. For robustness, they consider weeks ending on Monday, Wednesday and Friday (for a total of nine pair-endpoint combinations). They consider five trading models based on relative pair returns, relative pair (realized) volatilities and more complex characterizations of relative pair performance. Relative return/volatility predictions derive from a rolling historical window of 104 weeks. Using daily open-high-low-close prices for SPY, XLF, QQQQ and OIH to construct weekly metrics from earliest availability through April 4, 2008, they conclude that:

• In many cases, the models considered yield statistically significant sign predictions for pair relative returns and relative volatilities.
• Based on terminal wealth and weekly Sharpe ratio, rotation models outperform both buying and holding one asset in a pair and an equal weighting of both assets in a pair for eight of nine pair-endpoint combinations. Models based on predictions of pair relative returns are best for six of nine combinations.
• A very simple pair trading model based on a moving average of relative returns can outperform both benchmarks.
• More elaborate pair trading models may perform even better than the five considered.
• Pair trading models are generally riskier than equal weighting of both assets in a pair, but a priori less risky than buying and holding one asset in a pair.
• Trading frequencies (and therefore trading frictions) vary considerably across the five pair trading models.

The following chart, taken from the paper, visualizes the estimated distributions of gross weekly returns for the five pairs trading models for the SPY-XLF pair and weeks ending on Fridays over the sample period. See the paper for precise definitions of the models.

In summary, evidence from limited tests suggests that ETF pair trading based on relative returns/volatilities may outperform simple passive benchmarks.

Exclusion of trading frictions limits the persuasiveness of findings with respect to economic significance. Data snooping bias inherent in experimentation with multiple models/sampling variations on the same dataset may be material. Assumptions about return distributions may be critical to conclusions about statistical significance.

For research on other potential trading signals, see Blog Synthesis: Some Trading Indicators. See especially the related research summarized in the blog entries of 1/27/09 and 8/13/08.