Tactical Statistical Arbitrage

Tactical versus Strategic Exposure

November 2018. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Statistical arbitrage behaves similarly across markets
  • Volatility is the main performance driver
  • Attractive strategy for diversifying an equity portfolio

INTRODUCTION

Strategies like Value or Momentum are like staples that deserve a permanent allocation in investors portfolios. In contrast, other strategies are more like sunscreen, which is mainly used tactically to minimize the risk of getting a sunburn when going to the beach. Statistical arbitrage is a strategy that is likely more interesting on a tactical than strategic basis as returns are only attractive when volatility is high. In this short research note we will investigate statistical arbitrage across markets and the utilization as a tactical strategy for hedging equity portfolios (read Statistical Arbitrage in the US).

METHODOLOGY

We focus on all stocks in the US, European and Asian markets with a market capitalization of larger than $1 billion. The strategy is to create a diversified portfolio of pair trades, which will be dollar-neutral. Each pair consists of one long and one short position in stocks. In addition, the two stocks of a pair need to be cointegrated, which is measured with a one-year lookback and a maximum p-value of 0.3. A trade in a pair is entered when the z-score of the stock price ratio breaches +/- 2.0 and exited when the z-score reaches 0 subsequently. The z-score is calculated with a 21-day lookback. Each transaction incurs 10 basis points of costs. The portfolio is created sector-neutral in the US while cross-sector in other stock markets.

It is worth noting that statistical arbitrage is a sophisticated strategy that comes in all kind of forms and requires many assumptions. Our methodology is in line with academic research and relatively simple.

STATISTICAL ARBITRAGE ACROSS MARKETS

Peter Muller’s proprietary trading team at Morgan Stanley is often accredited for pioneering statistical arbitrage in the US stock market in the 1980s, although hedge fund managers like Edward Thorpe had also been employing the strategy at the same time. Since then the strategy has been explored by academics and rolled out to other markets by practitioners.<