Pairs trading is a well-known statistical arbitrage strategy that involves taking positions in two highly correlated stocks that have temporarily diverged from their historical price relationship, with the aim of profiting when the stocks converge. In this paper, Bill Sawarell and Can Inci examine the performance of a pairs trading strategy in three separate European equity markets over a 20-year period from January 1994 and forward. They find that the strategy produces positive average excess returns in all three markets, and that alphas are significantly positive both when controlling for market exposure using the CAPM and when controlling for exposure to the European Fama-French factors.

In this blog article, we will discuss the key findings of the paper, the implications of these findings, and some possible explanations for the profitability of the pairs trading strategy.

Key Findings

The authors find that the pairs trading strategy produces positive excess returns in all three European equity markets (Germany, France, and the UK) over the 20-year period from January 1994 to December 2013. The returns are market-neutral using both CAPM and Fama-French factor specifications, and the results are generally consistent across all three markets.

The authors also find that the returns of the strategy cannot be explained by common factor models, specifically using the CAPM and an extended version of the Fama-French model. However, the returns are generally in line with what is to be expected from a contrarian trading strategy such as pairs trading. The returns are negatively correlated to momentum exposures such as the Fama-French WML factor, and positively correlated to changes in volatility and negatively correlated to liquidity.

Implications

The authors’ findings have several implications. First, the fact that the pairs trading strategy produces positive excess returns in three separate European equity markets over a 20-year period lends credibility to the study and suggests that the strategy is not market-specific but rather general in nature. Second, the findings are generally consistent with previous research on the topic, most importantly with the Gatev et al. (2006) study that this study is based on. Third, the study provides an up-to-date analysis of the strategy using data that includes the recent financial crisis. Fourth, the study provides an out-of-sample test to the Gatev et al. (2006) study, and the authors replicate a subset of the original authors’ results and find that their algorithm produces results that compare favorably to theirs.

Possible Explanations

The authors cannot conclude with certainty what causes the profitability of the pairs trading strategy. Several explanations from previous studies are possible, and it may well be the case that the results are caused by a mixture of these, and not one explanation exclusively. The authors document that excess returns from the strategy are significantly related to both volatility and liquidity, and these empirical findings are in accordance with some of the existing explanations for the profitability of contrarian trading strategies.

One possible explanation is Lo & MacKinlay’s (1990) theory that contrarian trading returns can be explained by differences in reaction times between stocks. If there are differences in reaction times between stocks to firm-specific shocks, one would expect stocks to diverge more than what is justified in the long run over short time periods. This is exactly what a pairs trading strategy takes advantage of: temporary differences in security prices that are assumed to revert back to what has historically been normal.

Another possible explanation is that lack of short-term market liquidity causes short-term divergences between security prices. A lack of short-term liquidity implies that prices tend to move more than what is fundamentally justified in the short-term, to revert back over time as long-term liquidity is sufficient. This explanation fits the strategy as it is based on taking advantage of short-term divergences, and the authors find a negative relationship between the excess returns from the strategy and the liquidity factor, supporting this explanation.

It is also possible that overreactions in the market will lead to higher volatility, and this could explain why the returns are positively correlated to changes in volatility. An overreaction followed by a correction would create more volatility than a ‘direct’ move to the ‘correct’ value of a security.

While there is no agreed-upon explanation for the profitability of contrarian trading strategies, the authors’ findings suggest that the pairs trading strategy may be profitable due to a combination of these factors.

Conclusion

In conclusion, the pairs trading strategy produces positive excess returns in three separate European equity markets over a 20-year period. The returns are market-neutral using both CAPM and Fama-French factor specifications, and the results are generally consistent across all three markets. The authors’ findings are in line with what is to be expected from a contrarian trading strategy such as pairs trading, and their results are generally consistent with previous research on the topic.

While the authors cannot conclude with certainty what causes the profitability of the pairs trading strategy, several possible explanations are suggested by their findings, including differences in reaction times between stocks, lack of short-term market liquidity, and overreactions in the market leading to higher volatility. These explanations may help to shed light on why contrarian trading strategies, such as pairs trading, can be profitable.

Overall, this study provides valuable insights into the performance of the pairs trading strategy in European equity markets and contributes to the existing research on pairs trading and contrarian trading strategies more broadly.