Signal versus Noise in Pairs Trading

Two competing – but sometimes overlapping – approaches to 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 interpretation suggests that this is really a macro call using the pair as a proxy and the 10 year bond yield as a trigger.

You may wonder how to avoid over-reliance on those analysts forecasts and GDP predictions cited (see this from Larry Summers for why that might be a concern) when trying to apply this idea. Even the yield differential quoted as an advantage depends on how the trade is set up (money neutral vs beta neutral for example).

But what of history? Taking the 2001 and 2007 recessions as precedents, as the piece does, show the trade would have made 16% over 8 months and 35% over 18 months respectively (on a dollar neutral basis).

Not bad – but 2 trade entry data points is not a trend. And outside of those rather difficult-to-time periods SPG has strongly outperformed HCN by a wide margin since 2002 (this is shown on the Indexed Prices & Spread graph below).

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 – but the ideal approach tends to combine both.

 

Some visual analysis:

The back test results: