Are Pairs Trading Profits Robust to Trading Costs?

Abstract

We examine the impact of trading costs on pairs trading profitability in the U.S. equity market, 1963 to 2009. After controlling for commissions, market impact, and short selling fees, pairs trading remains profitable, albeit at much more modest levels. Specifically, we document a risk-adjusted return of about 30 basis points per month among portfolios of well-matched pairs that are formed within refined industry groups. Pairs trading exhibits a lower risk and lower return profile than a short-term reversal strategy that sorts stocks relative to their industry peers. Notably, both these types of contrarian investing are largely unprofitable after 2002.JEL Classification: G11, G12, G14We are greatly appreciative to the following people for their advice on various aspects of this paper-most notably, regarding the thorny issue of constructing reliable proxies for trading costs applicable to institutional investors:

Pairs trading and selection methods: is cointegration superior?

“…• The estimation of pairs trading transaction costs in this article is based on Do and Faff (2012). They consider these costs have three components: commissions, market impact (average one-way cost (commission + market impact) of 30 bps (10 + 20) in our sample) and short-selling constraints (constant loan fee of 1% per annum payable over the life of each trade).…”

“…As a consequence, transaction costs will be relatively low. In a pairs trading context, they will be estimated using Do and Faff (2012). A selection procedure starts every 21 trading days (about 1 month) and the trading/eligibility period of a pair lasts 126 trading days (about 6 months, 6 × 21 days).…”

Is pairs trading profitable on China AH-share markets?

“…A recent study by Mori and Ziobrowski (2011) finds that pairs trading is also profitable in the US REIT market. Do and Faff (2012) further examine the impact of trading costs on the performance of pairs trading and find that pairs trading remains profitable after controlling for commissions, market impact and short-selling fees. It should be noticed that the trading strategies documented in these papers are exposed to fundamental risk.…”

Does the 2008 short sale ban affect the enforcement of the Law of One Price? Evidence from Australia

“…Literature on the US market (see for example, D'Avolio, 2002) suggests short selling is relatively easy and cheap to execute, especially amongst large stocks. In the absence of literature on the matter, we follow Do and Faff (2011) and impose a conservative estimate of 1 per cent per annum to be payable over the duration the pair is open. As pairs open for an average of 2 months, that fee equates to about 17 bp (=100 bp/12 · 2) for each traded pair, thus represent a smaller portion than commissions and market impacts.…”

“…We answer this question by examining the underlying profitability of pairs trading after reasonable estimates of trading costs, namely brokerage fees, market impact and short selling fees. Similar to Do and Faff's (2011) study in the US context, we gather evidence on brokerage fees from the trading cost literature relevant to the Australian setting, as summarized in Table 7. Appendix A provides details of this estimation as well as market impact and short selling fees.…”