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Statistical arbitrage in the US equities market

By Marco Avellaneda and Jeong-Hyun Lee

Abstract

We study model-driven statistical arbitrage in US equities. Trading signals are generated in two ways: using Principal Component Analysis (PCA) or regressing stock returns on sector Exchange Traded Funds (ETFs). In both cases, the idiosyncratic returns are modelled as mean-reverting processes, which leads naturally to 'contrarian' strategies. We construct, back-test and compare market-neutral PCA- and ETF-based strategies applied to the broad universe of US equities. After accounting for transaction costs, PCA-based strategies have an average annual Sharpe ratio of 1.44 over the period 1997 to 2007, with stronger performances prior to 2003. During 2003-2007, the average Sharpe ratio of PCA-based strategies was only 0.9. ETF-based strategies had a Sharpe ratio of 1.1 from 1997 to 2007, experiencing a similar degradation since 2002. We also propose signals that account for trading volume, observing significant improvement in performance in the case of ETF-based signals. ETF-strategies with volume information achieved a Sharpe ratio of 1.51 from 2003 to 2007. The paper also relates the performance of mean-reversion statistical arbitrage strategies with the stock market cycle. In particular, we study in detail the performance of the strategies during the liquidity crisis of the summer of 2007, following Khandani and Lo [Social Science Research Network (SSRN) working paper, 2007].Alternative investments, Cointegration, Correlation modelling, Quantitative trading strategies,

DOI identifier: 10.1080/14697680903124632
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