Marco Avellaneda, CIMS, joint work with Jeong Hyun Lee

ABSTRACT:

We study model-driven statistical arbitrage strategies in U.S. equities. Trading signals are generated in two ways: using Principal Component Analysis and using sector ETFs. In both cases, we consider the residuals, or idiosyncratic components of stock returns, and model them as a mean-reverting process, which leads naturally to contrarian trading signals.

The main contribution of the paper is the back-testing and comparison of market-neutral PCA- and ETF-based strategies over the broad universe of U.S. equities. Back-testing shows that, after accounting for transaction costs, PCA-based strategies have an average annual Sharpe ratio of 1.44 over the period 1997 to 2007, with much stronger performances prior to 2003: during 2003-2007, the average Sharpe ratio of PCA-based strategies was only 0.9. On the other hand, strategies based on ETFs achieved a Sharpe ratio of 1.1 from 1997 to 2007, butexperience a similar degradation of performance after 2002. We introduce a method to take into account daily trading volume information in the signals (using trading time as opposed to calendar time), and observe significant improvements in performance in the case of ETF-based signals. ETF strategies which use volume information achieve 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 some detail the performance of the strategies during the liquidity crisis of the summer of 2007. We obtain results which are consistent with Khandani and Lo (2007) and validate their unwinding theory for the quant fund drawndown of August 2007