Is pairs trading dead?

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Bad news everybody, according to my calculations, ( which I sincerely hope are incorrect) the classical pairs trading is dead. Some people would strongly disagree, but here is what I found:

Let’s take a hypothetical strategy that works on a basket of etfs:
['SPY','XLY','XLE','XLF','XLI','XLB','XLK','IWM','QQQ','DIA']
From these etfs 90 unique pairs can be made. Each pair is constructed as a market-neutral spread.

Strategy rules:
On each day, for each pair, calculate z-score based on 25-day standard deviation.
If z-score > threshold, go short, close next day
If z-score
To keep it all simple, the calculation is done without any capital management (one can have up to 90 pairs in portfolio on each day) . Transaction costs are not taken into account either.

To put it simply,  this strategy tracks one-day mean reverting nature of market neutral spreads.
Here are the results simulated for several thresholds:

No matter what threshold is used, the strategy is highly profitable in 2008, pretty good throuh 2009 and completely worthless from early 2010.
This is not the first time I came across this change in mean-reverting behavior in etfs. No matter what I’ve tried, I had no luck in finding a pairs trading strategy that would work on ETFs past 2010. My conclusion is that these types of simple stat-arb models just don’t cut it any more.

2013-02-03 18:05:49

Source: http://matlab-trading.blogspot.com/2012/12/is-pairs-trading-dead.html