November 26th, 2019

Pairs Trading in Information Technology Sector

By Umang Koul

India's technology sector has been in the news off late for many reasons- the slowdown in the Global Economy, technology advancements and its resultant impact amongst the industry players and their stakeholders. Traditionally, players in this sector have exploited the cost arbitrage (the cost of providing the services in India as compared to developed markets) and technical talent pool availability in India, as a growth strategy with minimal or no differentiation in the services provided by the players. This growth strategy has worked very well so far. 

We undertook an interesting study on analysing whether Pairs Trading strategy, can be an effective strategy to be deployed in this sector. Our analysis was for a period of 8 years, starting from 2011 to 2019. We identified 5 stocks to be analysed for Pairs trading strategy- Tata Consultancy Services (TCS), Infosys (INFY), Hindustan Computers Limited (HCL), WIPRO and Tech Mahindra (TECHM). The analysis involved comparing Pairs trading strategy performance with the Performance of an equally weighted long portfolio, with the composition of  same five stocks.  

For beginners, let's start with a basic definition of Pairs trading. Pairs trading is based on the concept of "Law of One Price". Simply put, two companies with identical businesses should have same stock returns. Let's assume Companies A and Companies B are in the same industry sector and offer the same products or services to a similar set of customers and similar market share and even their raw materials/resources are sourced from the same set of markets. Then, one would expect the returns to be the same. At any point in time, if they diverge, we assume it is a short term anomaly (market inefficiency) and expect them to revert to normalcy. 

We leverage these short term market inefficiencies, through the concept called " Relative Value Arbitrage".  One can study about the origin of Pairs trading and attributes to identify the stocks for Pairs trading opportunities along with signals for divergence and convergence, from ALPHABETA Guide. For our research, we used ALPHABETA Guide to simulate and backtest the performance of Pairs Trading in the IT sector industries from Sep 11 to Sep 19. The returns observed were captured semi-annually as is shown in the screenshot from the app below. The compounded annual growth rate (CAGR) for the same was 28%.

 Semi-annual performance of IT sector stocks in India using Pairs Trading(Source : Alphabeta Guide App)

We compared the performance of the Pairs trading strategy with an equal-weighted portfolio with the composition of  5 stocks. The stock basket included TCS, INFY, HCL, WIPRO and TECHM. The CAGR performance of the equal-weighted portfolio was close to 19.7% ~ 20%, as compared to the Pairs trading portfolio which gave a CAGR of 28%. This was based on the research done for the past 8 years data.

  Semi-annual performance of equally weighted portfolio of IT sector stocks in India(Source : Alphabeta Guide App)

Our study has proven that Pairs trading can be an effective strategy to be deployed in India's Information Technology sector. Other sectors, which have proven very effective for Pairs trading are Banking, Energy and Industrials. One can learn more about Pairs Trading strategy through ALPHABETA
ALPHABETA provides the platform to find these pairs, simulate/backtest the performance of these pairs and create real-time virtual portfolios based on this pairs trading strategy.