Pairs Trading Strategy and Connected Stocks: Evidence from China

Abstract

We develop a pairs trading strategy in China’s stock market based on non-fundamental comovement driven by fund common ownership. The stocks connected through their common mutual fund owners is used to identify pairs, and the divergence from connected stocks is used for the trading strategy. Specifically, a long-short hedging strategy based on return divergence can achieve 1.73% monthly return. Because the pairs trading strategy is based on non-fundamental comovement driven by fund flows, the trading profits is more pronounced following months with fund outflows, proxied by negative market returns and high market volatility. Finally, we show that the profits of the pairs trading are related to investor attention, lottery features, valuation uncertainty, market beta or downside beta, arbitrage risk and past one-month winners or losers.

Keywords: Connected stocks, Pairs trading strategy, Chinese stock market

JEL Classification: G11 G12 G15