Pairing Macro Trades In An ETF

One of the first trading strategies most investors are introduced to is the idea of a pairs trade. Why don’t we ever really talk about it with ETFs?

Back in the stone ages when I was getting my MBA, I vividly remember a lecture by my investments professor. The example he used was not unique, and one I’ve heard countless times since: Coke and Pepsi.

As little-baby stock analysts, our homework over the rest of the semester was to look at the fundamentals of these two companies and make a recommendation on which stock we would consider the “winner” and which we’d consider the “loser.” In short, we had to make a call on the relative value between two similar things.

Having never been interested in the food-and-beverage sector, and not being a very good stock analyst (this was 1991; I was a child), I decided Pepsi’s (EPE) diversification balance sheet looked more interesting than Coca-Cola’s (KO), so I picked PEP as my winner. We all put on notional trades in class: I “bought” $10,000 worth of PEP, and I “shorted” the same amount of KO. (You can look up an individual stock and what ETFs own them on our ETF.com Stock Finder Tool.)

Not So Simple

Of course I was wrong. My KO (Coke) position rose 24% (costing me $2,400). My PEP (Pepsi) position rose 17%, giving me a gain of $1,700. My net loss was $700.

But importantly, at no point in this virtual trade was I exposed to the actual price movement of the beverage market. This happened to be a rising market, which had no impact on me. I was market-neutral, being both long and short the sector.

Since that long-ago lesson, I’ve often come back to the idea of pairs trades. But since then, I’ve also realized that, for most investors (and certainly for me), picking individual stocks to be winners or losers is a bit of a mug’s game (as Larry Swedroe pointed out earlier this week on ETF.com)

Indeed, in the modern world, the active management decision most of us make—even as we claim to be passive investors—is in our asset allocations. My decision to be 70% in equity, for instance, is a decision. I could be 100% in equity. I could be 50%. I could be in cash. I might not change my mind often or execute many trades, but exposure is by nature, a decision.

Challenging Yourself

The framework of pairs trading is a useful one to challenge those decisions. Consider the basic decision of how much developed versus emerging market exposure you have. This is not a simple decision. Consider the performance over the last year:

(MXEF in blue here is the MSCI Emerging Markets Index; MXWO in white is the MSCI World Index, which is all developed markets.)

Sure, the markets have been generally down, but the emerging markets have been crushed. And looking at 10 years, emerging markets—in hindsight—look like nothing so much as a missed 50% performance opportunity.

Still, the reason most of us invest outside the home country isn’t pure returns—it’s diversification and returns within a portfolio. And emerging markets deliver some of that diversification benefit:

As rolling 30-day correlations go, this is actually pretty good. The mean here is about 65. We’re currently in a period of high correlation (which often happens in down markets), but historically, emerging markets helped.

How A Pairs Trade Would Work Here

So how would you think about this as a pairs trade? Well, let’s say you had a firm conviction that developed markets were going to head broadly into recession, and emerging markets—already heavily clobbered—offered a ray of hope. You really have a few choices.

1. You can sell all your domestic equities and just go long emerging markets. ETFs make that easy. This leaves you completely exposed to both the beta of the global equity markets, and to the riskiest part of that asset class. If you’re right, you’ll crush it. If you’re wrong, well, you’ll be crushed.
2. You can take just the negative bet—sit on a pile of cash, and short the developed markets. Again, shorting an ETF or buying (and monitoring!) an inverse ETF position is pretty simple. And again, if you’re right, you’ll do well. If you’re wrong, well, shorts have infinite downside, so buckle up.
3. You can put on a pairs trade. In this case, you could go long the emerging markets, and short the developed markets.

Profiting From The Spread

This last strategy does a few interesting things. If you’re correct, you’ll profit from the spread between emerging and developed markets, regardless of whether the overall global equity market is up or down. In other words, you don’t have to make a call on “equity” at all here. If you’re wrong, you lose the spread—again, regardless of whether the markets are up or down.

Pretty much any macro factor of the markets can be thought of in this way: stocks versus bonds. Growth versus value. Heck, even sector rotation strategies can be implemented as long/short pairs. ETFs provide all the tools you need.

Next Wednesday, Jan. 16 at 2 p.m. ET, I’m hosting a webinar with Dave Mazza, managing director, head of product at Direxion, to talk about what the current macro environment is telling us, and how this idea of using relative-value convictions (hopefully smarter than my KO/PEP trade!) can help manage risk and create opportunities in 2019.

I hope you’ll join us. You can register here.

Dave Nadig can be reached at [email protected]