Pairs trading strategy: A performance assesment of UK equities

Abstract

Pairs trading strategy is commonly applied in the financial industry as a mechanism of implementing self financing investment strategies across various asset classes. The strategy however finds popular application among hedge funds investing in equity markets. Academic literature providing insights on the characteristics of this strategy’s returns remains scanty and existing literature is focused on the US equity markets, this creates the need to expand the current knowledge base on this strategy.

This study tests the strategy’s profitability based on UK equities. The study investigates risk-return characteristics of portfolios of pairs and the strategy’s performance during different market conditions. Data used for this study is extracted from the STOXXEurope 600 index where only Pound(£) denominated stocks are utilized. The studied time period spans from January 2000 to May 2014. The squared sum of deviations method is applied to identify tradable pairs of stocks.

Results indicate that pairs trading is a profitable strategy in the UK equity market. The general high-risk high-return relationship also holds for trading returns. It is also observed that forming smaller portfolios yields higher returns than larger portfolios however with increased risk. Portfolio risk can be reduced by increasing the number of pairs in a portfolio and increasing the universe of available stocks to form pairs. Lastly, pairs trading generates higher returns during market downturns also in the UK.