Profitable Pair Trading: A Comparison Using the S&P 100 Constituent Stocks and the 100 Most Liquid ETFs

Abstract

The motivation for this paper is to find out whether exchange traded funds (ETFs) are more suitable financial instruments for a pair trading strategy than stocks. The main advantage of pair trading ETFs is that ETFs cannot go bankrupt, which is not the case for shares. Thus, one of the greatest risks known for pair trading is eliminated.

Indeed, we find that an adaptive long-short strategy is more consistently profitable when it is applied to pairs consisting of ETFs rather than of shares, with an average out-of-sample information ratio of around 1 and 0, respectively.

By extending the in-sample period and decreasing the out-of sample period from 75%-25% to 83%-17% of the sample we were able to increase the average out-of-sample information ratio from 1 to 1.7 for ETFs and from 0 to 0.2 for shares. Yet, further improvement was achieved by preselecting pairs of ETFs and shares with the highest in-sample information ratios in the in-sample period. The average out-of-sample information ratios obtained for fifty such pairs selected from ETFs and shares were 2.93 and 0.46, respectively.

Keywords: Statistical arbitrage, ETFs, pairs trading, time adaptive models

JEL Classification: C00, C10, C50, G00, G11