...but a little bit helps.



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Two competing – but sometimes overlapping – approaches to relative value / pairs trading are to take either a fundamental ‘signal’ view based on changes to factors such as the accounts, the economy, the CFO’s penchant for recognizing revenue early and so on; and the ‘noise’ approach whereby the trader concentrates on the divergence in value of the instruments for reasons unrelated to changes in fundamental conditions.

Bloomberg occasionally publish pairs trading ideas in the first category. Like this one for HCN/SPG. One reading suggests that it is really a macroeconomic call using the pair as a proxy and the 10 year bond yield as a trigger.

Should pragmatism be a consideration, you may wonder how to avoid over-reliance on those analysts forecasts and GDP predictions cited when applying this idea (see prior blog or this from Larry Summers for why this might be a concern). Even the yield differential heralded as an advantage depends on how the trade is set up - money neutral vs beta neutral for example - thus potentially mitigating the joy of the headline.

But onto the history. Taking the 2001 and 2007 recessions as precedents, as the piece does, the trade would have made 16% over 8 months and 35% over 18 months respectively (on a dollar neutral basis). Outside of those rather difficult-to-time periods SPG has outperformed HCN by a wide margin since 2002 (this is shown on the Indexed Prices & Spread graph below).

Not bad. But 2 trade entry data points is not a trend.

The noise approach (here lend some rigour with cointegration) would have used far smaller holding times inside both those recessionary periods. Taking the August 2007 to March 2009 meltdown, for example, an uncomplicated strategy (backtest graph below) would have traded 4 times for a total gain of 17% (and an average return on capital invested per trade of 4.2%). The total holding period of 2 months means, once annualized, that ‘noise’ beat ‘signal’ by over 4 to 1.

Horses for courses - the ideal approach tends to combine both.