Follow Up to Qusma’s IBS and Relative Value Mean-Reversion

24Dec12

Qusma is one of my favorite new blogs. This is a follow up to their post IBS and Relative Value Mean-Reversion in which they test a pairs trading strategy based on various (mostly international) ETFs under-reacting to changes in the US market.

Read Qusma’s post as a primer. I’ll contribute to the discussion by adding an equity curve from 1997. First, excluding trading frictions…

20121224.01
[logarithmically-scaled, growth of $1, frictionless]

Strategy rules (using Qusma’s universe of 32 mostly international ETFs):

If SPY IBS (Internal Bar Strength) < 50% and ETF IBS > 80% at today’s close, go long SPY and short the ETF at today’s close. If SPY IBS > 50% and ETF IBS < 20%, go long the ETF and short SPY. Close all positions at the following close.

Allocate 25% of the portfolio to each pair unless more than 4 pairs are active. If more than 4 pairs are active, split the portfolio evenly amongst the pairs.

One last bit of slickness – rather than using Qusma’s equal dollar weighting, weight the pairs to equalize the standard deviation of daily returns over the last 63-days (1-quarter). That means the ETF will usually receive a lower weighting than SPY (because the international ETFs tend to be more volatile).

Of course, transaction costs and slippage would be a major concern with such an active strategy, so here’s the same test with 0.10% round-trip cost included.

20121224.02
[logarithmically-scaled, growth of $1]

As Qusma notes, the strategy is just a historical curiosity at this point as all of its mojo has clearly been traded out.

Seeing a strategy with the type of equity curve this one exhibited until 2003 always gets the nerd juices flowing. But I’ve sliced and diced the strategy a dozen ways to better understand if some change would make the strategy productive again (like trading the pair when the ETF over-reacts to the SPY rather than under-reacts) to no avail.

Quite a bit of work went into putting the strategy through its paces, so I thought I would share to help get other readers’ nerd juices flowing.

Happy Trading,
ms

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2 Responses to “Follow Up to Qusma’s IBS and Relative Value Mean-Reversion”

  1. 1 Alex Argyros

    Thank you for the very interesting work.

    Do you have any idea why the equity curve changes so precipitously around 2003? Clearly, the market changed at that time, but it’s not obvious to me in what way the post 2003 market affected this strategy.

    • 2 MarketSci

      Hello Alex – not completely. I started to break down the parts of the trade to better understand what led to the shift. I got distracted by other ideas and didn’t pick it back up (hard to get motivated when it doesn’t affect today’s bottom line =). On the to do list to dig back in. michael


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