pairs trade

After further research, Nichols adds Portfolio D’s manager in the list of managers approved for use by JAG. One of the appeals of manager D was the manager’s use of paired trades. For example, in the most recent quarter the manager had in place a pairs trade between an industrial and a consumer durables stock. The industrial was overweighted by 1.5% and the consumer durable was underweighted by 1.5% versus the portfolio’s benchmark. The trade was not successful and the manager reversed the trade by restoring both positions to an equal weight versus the benchmark. In its place the manager initiated a new pairs trade between two different consumer staples companies. This time the over and underweights were only 1.0%.

Determine whether the active risk of Manager D most likely increased or decreased as a result of the two pairs trade actions taken.

The first pairs trade was a bad pairs trade because it was implemented incorrectly. By undoing that, the active risk decreased.

The second pairs trade looks like it was correct pairs trade (meaning same industry & same characteristics) so I would say the active risk decreased.

Whats the answer?


The effect on active risk is unclear:

  • Decreasing the over/underweights would decrease the active risk.
  • But active risk is also affected by covariance within the pair and the covariance likely went up, increasing the active risk. The covariance (and correlation) should increase because the manager went from a pair of stocks in different sectors to a pair in one sector.

I am confused here. Low correlation meaning low variance right? How does it increases active risk?

Low correlation (of returns) does not necessarily mean low variance (of returns).

Furthermore, correlation of returns compares returns of two securities; variance of returns concerns only one security.

Yes but how does it plays out here?