Pairs Trading on International ETFs

Abstract

Pairs trading is a popular, market-neutral trading strategy among finance practitioners that has been recently evaluated in a number of papers. Since it is a successful trading strategy, allowing for multiple implementations of solid underlying ideas, it is interesting to further explore the underlying factors for its success. In this paper we do so using a large family of international exchange traded funds (ETFs), a recent instrument of choice among professionals. Using ETFs from across the world we examine the performance of the pairs trading strategy and the various potential sources of its profitability. Our results show that pair trading is a profitable strategy in the context of international ETFs. There is a clear difference between the long and short component of the pairs, maybe in contrast to the common perception on the profitability of long trades. Finally, we explore the sources of the strategy’s total profitability and find that it can be explained by a number of fundamentals, the most important being the earnings per share, the dividend yield and the unemployment rate.

Keywords: convergence/divergence of prices, exchange traded funds, ETF, Fama-French, international asset pricing, long and short strategies, market neutral strategies, mean reversion