Statistical Arbitrage

Active portfolio management involves various strategies to outperform the market benchmark. Two unique strategies are statistical arbitrage and event-driven strategies. These strategies heavily rely on quantitative data and are implemented systematically, but also incorporate the fund manager’s judgment.

Statistical Arbitrage

Statistical arbitrage, often referred to as “stat arb”, is a financial strategy that leverages statistical and technical analysis to exploit pricing anomalies. This strategy heavily relies on data such as stock price, dividend, trading volume, and the limit order book. The analytical tools used in statistical arbitrage range from traditional technical analysis, sophisticated time-series analysis and econometric models, to machine-learning techniques.

Application of Statistical Arbitrage

Portfolio managers often employ statistical arbitrage to capitalize on mean reversion in share prices or opportunities created by market microstructure issues. A common and straightforward statistical arbitrage strategy is pairs trading. This strategy uses statistical techniques to identify two securities that have historically shown a high correlation. For instance, Coca-Cola and PepsiCo often move in tandem due to their similar business models. If the price relationship of these two securities deviates from its long-term average, managers expecting the deviation to be temporary would go long on the underperforming stock (e.g., Coca-Cola) and simultaneously short the outperforming stock (e.g., PepsiCo). If the prices do converge to the long-term average as forecast, the investors close the trade and realize a profit.

Risks and Challenges

The primary risk in pairs trading and most other mean-reversion strategies is that the observed price divergence may not be temporary but due to structural reasons. Therefore, risk management is crucial for the success of such strategies, and investors often employ stop-loss rules to exit trades when a loss limit is reached. Identifying the pairs of stocks for trading is another challenge, which can be addressed either by using a quantitative approach and creating models of stock prices or by using a fundamental approach to judge the two stocks whose prices should move together for qualitative reasons.

Market Microstructure-Based Arbitrage Strategies

In the United States, many market microstructure–based arbitrage strategies leverage the NYSE Trade and Quote (TAQ) database and often involve extensive analysis of the limit order book to identify very short-term mispricing opportunities. For example, a temporary imbalance between buy and sell orders may trigger a spike in share price that lasts for only a few milliseconds. Only those investors with the analytical tools and trading capabilities for high-frequency trading can capture such opportunities, usually within a portfolio of many stocks designed to take advantage of very short-term discrepancies.

Event-Driven Strategies

Event-driven strategies are investment approaches that aim to exploit market inefficiencies that may occur around corporate events. These events can include mergers and acquisitions, earnings or restructuring announcements, share buybacks, special dividends, and spinoffs. A real-world example of an event-driven strategy is risk arbitrage associated with merger and acquisition (M&A) activity, such as the acquisition of LinkedIn by Microsoft in 2016.

Types of Transactions

In a cash-only transaction , the acquirer proposes to purchase the shares of the target company for a given price. The stock price of the target company typically remains below the offered price until the transaction is completed. An arbitrageur could buy the stock of the target company and earn a profit if and when the acquisition closes. For instance, when Facebook acquired Instagram, arbitrageurs could have profited from the price difference.

In a share-for-share exchange transaction, the acquirer uses its own shares to purchase the target company at a given exchange ratio. A risk arbitrage trader normally purchases the target share and simultaneously short-sells the acquirer’s stock at the same exchange ratio. Once the acquisition is closed, the arbitrageur uses his or her long positions in the target company to exchange for the acquirer’s stocks, which are further used to cover the arbitrageur’s short positions.

Risks and Considerations

The first challenge in managing risk arbitrage positions is to accurately estimate the risk of the deal failing. An M&A transaction, for example, may not go through for numerous reasons. A regulator may block the deal because of antitrust concerns, or the acquirer may not be able to secure the approval from the target company’s shareholders. If a deal fails, the price of the target stock typically falls sharply, generating significant loss for the arbitrageur. Hence, this strategy has the label “risk arbitrage.”

Another important consideration that an arbitrageur has to take into account is the deal duration. At any given point in time, there are many M&A transactions outstanding, and the arbitrageur has to decide which ones to participate in and how to weight each position, based on the predicted premium and risk. The predicted premium has to be annualized to enable the arbitrageur to compare different opportunities. Therefore, estimating deal duration is important for accurately estimating the deal premium.

Practice Questions

Question 1: Statistical arbitrage is a strategy that uses statistical and technical analysis to exploit pricing anomalies. One popular and simple statistical arbitrage strategy is pairs trading. In pairs trading, two securities that are historically highly correlated with each other are identified. When the price relationship of these two securities deviates from its long-term average, managers that expect the deviation to be temporary go long the underperforming stock and simultaneously short the outperforming stock. What is the biggest risk in pairs trading and most other mean-reversion strategies?

1. The biggest risk is that the observed price divergence is temporary.
2. The biggest risk is that the observed price divergence is not temporary and might be due to structural reasons.
3. The biggest risk is that the observed price divergence is due to market microstructure issues.

Answer: Choice B is correct.

The biggest risk in pairs trading and most other mean-reversion strategies is that the observed price divergence is not temporary and might be due to structural reasons. Pairs trading relies on the assumption that the price relationship between two historically correlated securities will revert to its long-term average. If the price divergence is not temporary but is due to structural changes in the market or the companies involved, the strategy may result in significant losses. For example, if one of the companies in the pair undergoes a significant change, such as a merger or bankruptcy, the historical correlation between the two securities may no longer hold. In such cases, the price divergence may not revert to the mean, and the pairs trading strategy may fail. Therefore, it is crucial for managers using this strategy to monitor the underlying fundamentals of the securities involved and to be aware of any potential structural changes that could affect the price relationship.

Choice A is incorrect. The biggest risk is not that the observed price divergence is temporary. In fact, pairs trading relies on the assumption that the price divergence is temporary and will revert to its long-term average. If the price divergence is temporary, the strategy can potentially generate profits when the price relationship reverts to the mean.

Choice C is incorrect. While market microstructure issues can affect the execution of pairs trading and other mean-reversion strategies, they are not the biggest risk. Market microstructure issues, such as bid-ask spreads and market liquidity, can affect the cost and feasibility of implementing the strategy, but they do not fundamentally alter the price relationship between the two securities involved in the pairs trade.

Question 2: An investor is considering using an event-driven strategy to exploit potential market inefficiencies. One of the strategies he is considering is risk arbitrage associated with merger and acquisition (M&A) activity. In a share-for-share exchange transaction, he plans to purchase the target company’s shares and simultaneously short-sell the acquirer’s stock at the same exchange ratio. However, he is aware that there are risks associated with this strategy. Which of the following is the most significant risk that he should consider in managing his risk arbitrage positions?

1. The acquirer may not be able to secure the approval from the target company’s shareholders.
2. The regulator may block the deal because of antitrust concerns.
3. Both A and B are significant risks that could lead to the deal failing and the price of the target stock falling sharply, generating significant loss for the investor.

Answer: Choice C is correct.

Both A and B are significant risks that could lead to the deal failing and the price of the target stock falling sharply, generating significant loss for the investor. In a risk arbitrage strategy associated with M&A activity, the investor is betting on the successful completion of the deal. If the deal fails for any reason, the price of the target company’s stock is likely to fall sharply, leading to a significant loss for the investor. The acquirer not being able to secure the approval from the target company’s shareholders (Choice A) and the regulator blocking the deal because of antitrust concerns (Choice B) are both significant risks that could lead to the deal failing. Therefore, the investor needs to carefully consider these risks when managing his risk arbitrage positions. It is important for the investor to conduct thorough due diligence and closely monitor the progress of the deal to manage these risks effectively.

Choice A is incorrect. While the acquirer not being able to secure the approval from the target company’s shareholders is a significant risk, it is not the only risk that the investor needs to consider. The regulator blocking the deal because of antitrust concerns is also a significant risk that could lead to the deal failing.

Choice B is incorrect. While the regulator blocking the deal because of antitrust concerns is a significant risk, it is not the only risk that the investor needs to consider. The acquirer not being able to secure the approval from the target company’s shareholders is also a significant risk that could lead to the deal failing.

Glossary

• Statistical Arbitrage: A strategy that involves making a large number of trades to take advantage of pricing inefficiencies.
• Event-Driven Strategies: Investing based on anticipated events that are expected to impact the price of a security.
• Pairs Trading: A statistical arbitrage strategy that involves going long on an underperforming stock and short on an outperforming stock.
• Mean Reversion: The theory suggesting that prices and returns eventually move back towards the mean or average.
• Event-driven strategies: Investment approaches that aim to exploit market inefficiencies that may occur around corporate events.
• Risk arbitrage: An investment strategy that exploits the price differences between the current market price of a target company and the price offered by the acquirer.

Portfolio Management Pathway Volume 1: Learning Module 2: Active Equity Investing: Strategies; LOS 2(h): Describe active strategies based on statistical arbitrage and market microstructure.