In this paper we provide the first comprehensive UK evidence on the profitability of the pairs trading strategy. Evidence suggests that the strategy performs well in crisis periods, so we control for both risk and liquidity to assess performance. To evaluate the effect of market frictions on the strategy we use several estimates of transaction costs. We also present evidence on the performance of the strategy in different economic and market states. Our results show that pairs trading portfolios typically have little exposure to known equity risk factors such as market, size, value, momentum and reversal. However, a model controlling for risk and liquidity explains a far larger proportion of returns. Incorporating different assumptions about bid ask spreads leads to reductions in performance estimates. When we allow for time-varying risk exposures, conditioned on the contemporaneous equity market return, risk adjusted returns are generally not significantly different from zero.

Keywords: Pairs Trading; Statistical Arbitrage; Hedge Funds; Asset Allocation

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