I recently came across a paper titled “Pairs Trading on International ETFs” on quantpedia.com. A Sharpe Ratio of 1.66 and an “indicative performance” of 20.6%, as reported by quantpedia, seemed amazing. So, I decided to explore the strategy and accompanying research paper myself.
[Wow, I’ve never seen such a good looking equity curve before… except maybe Madoff’s… ]
The basics of the strategy are simple to understand. The research paper uses a metric that gauges the historical average distance between cumulative returns of two ETFs, and picks pairs that have the highest historical average distance to trade. Once the current “return difference” of two ETFs exceeds the pair’s historical average distance by a certain threshold, we enter the pair trade and exit in 20 days or when the pair converges, which ever comes first. 22 country ETFs are used, including countries like Italy, Germany, Australia, and Canada.
The biggest concern I had when reading the paper was that it just assumes convergence for country ETFs–there is no measure of price co-movement between a pair of country ETFs. The only way it “measures” past price movement between a pair is with the historical average described above. Especially with the recent events in Europe, assuming that a pair with a high historical average distance will converge in the near future seems dangerous.
A backtester (using Python and the immensely helpful pandas library) coded with the entry and exit conditions specified in the paper produced very different results: a 1.5% CAGR, with a -20% max drawdown. Granted I used data from June 2001 to today, and the paper used data from April 1996 (before some of the 22 ETFs in the basket even existed…) through 2009, but the vastly different slopes in the equity curves speak for themselves.
[What happened to the pair trading strategy’s “returns”?]
Something seems off: maybe there’s a bug in my code (in the process of checking). Nonetheless, through this exercise, I’ve learned that verifying a strategy’s returns for yourself is always a wise idea.
Happy new year by the way. Remember this, whenever you’re starting something new: