Pairs Trading: Performance of a Relative-Value

We test a Wall Street investment strategy, ‘‘pairs trading,’ ’ with daily data over 1962–2002. Stocks are matched into pairs with minimum distance between normal-ized historical prices. A simple trading rule yields average annualized excess returns of up to 11 % for self-financing portfolios of pairs. The profits typically exceed conser-vative transaction-cost estimates. Bootstrap results suggest that the ‘‘pairs’ ’ effect differs from previously documented reversal profits. Robustness of the excess returns indicates that pairs trading profits from temporary mispricing of close substitutes. We link the profitability to the presence of a common factor in the returns, different from conventional risk measures. Wall Street has long been interested in quantitative methods of specula-tion. One popular short-term speculation strategy is known as ‘‘pairs trading.’ ’ The strategy has at least a 20-year history on Wall Street and is among the proprietary ‘‘statistical arbitrage’ ’ tools currently used by hedge funds as well as investment banks. The concept of pairs trading is disarmingly simple. Find two stocks whose prices have moved together historically. When the spread between them widens, short the winner and buy the loser. If history repeats itself, prices will converge and the arbi-trageur will profit. It is hard to believe that such a simple strategy, based solely on past price dynamics and simple contrarian principles, could possibly make money. If the U.S. equity market were efficient at all times, risk-adjusted returns from pairs trading should not be positive. In this article, we examine the risk and return characteristics of pairs trading with daily data over the period 1962 through December 2002