seemed that these regime shifts occurred. Our pair trading strategy’s returns improveddramatically, producing a full period Sharpe Ratio close to 1 and a max drawdown of -35%.
II. Premise: “Pairs Trading on International ETFs” Paper
We decided to base our project on the premise of the quantitative financial research papertitled “Pairs Trading on International ETFs”, authored by Schizas, Thomakos, and Wang. In theirpaper, Schizas and his colleagues developed an international ETFs pair trading strategy thatproduced spectacular results but did not seem to have a strong statistical foundation.The authors of the paper used 23 international ETFs, representing countries such as theUSA, Germany, Brazil, Japan, and even smaller countries like Belgium and Malaysia. Theauthors implemented their backtest using a rolling window: They had a 120-day formationperiod in which they ranked all pairs of international ETFs and selected the top five to trade in asimple 1-to-1 ratio. Then they had a 20-day trading period in which they calculated the ex-postreturns of the ETF pairs that they selected in the formation period. Rolling these two windowsforward together by 20 days produced ex-post returns for another 20 days.To order the ETF pairs, the authors used the average absolute difference between thecumulative returns of two ETFs starting from the beginning of the 120-day formation period. Indoing so, they were essentially betting that two international ETFs whose prices have shown todiverge a lot will tend to converge in the future. However, they did not offereither a fundamentaleconomic reason or statistical evidence to explain such convergence behavior.When assessing the performance of their strategy, theauthors neglected to provide basicperformance metrics such as monthly return, compound annualized growth rate, or maxdrawdown numbers for their strategy. They only provided a single bar chart of monthly returnsand a few equity curves that are depicted below.