One of the difficulties in share market investing is that you may invest in an individual stock – due to your positive opinion on an individual company’s prospects – only to see its share price stumble in a market-wide sell-off. This is because when you buy an individual stock, you can’t separate market risk from company risk. Of course, sophisticated institutional investors – such as hedge funds – often get around this problem through what’s known as “pairs trading”…
In its classic form, ‘pairs trading’ exploits any short-term deviation from the historical pricing pattern of two strongly correlated stocks. For example, Coca-Cola and Pepsi, or Ford and General Motors, or BHP and Rio, generally trend up and down over time more or less in synch. However, when the normal relationship skews off-course (say, Rio heads up while BHP drops), pairs-traders sense an investment opportunity. To take advantage of temporarily-separated stock pair prices, traders buy (or go long) the company they expect to increase in value while simultaneously ‘shorting’ the correlated stock that they expect to drop in value.
Pairs-trading, however, need not require the assumption of a “reversion to the mean” between two share prices. It can also be used to take a view that the performance of one or more specific companies will, over time, be better than competitor companies or the market or sector overall. The advantage of pairs-trading in this sense it that is allows one to bet on the relative success of a particular company’s business model or strategy – while hedging against broader sector or market declines.
Recent local examples of pairs-trading in action would include “going long” the shares of online classified websites such as carsales.com.au, while simultaneously shorting the old-world media stocks such as Fairfax. Globally, investors might go long Apple or Google while shorting Microsoft, based on a view of changing market dominance in the tech world.
For the typical retail investor, however, the mechanics of shorting individual stocks can be quite complicated. Full broking services do offer stock shorting capabilities – at a cost – while online share-trading sites such as Commsec make it available only through either contracts for difference (CFDs) or exchange traded options (ETOs). These are highly leveraged and quite sophisticated investment tools which are not for the faint hearted.
All up, traditional pairs-trading between individual stocks is possible but not easy to implement.
That said, with the introduction of the BetaShares Australian Equities Bear Hedge Fund Fund (ASX: BEAR), new opportunities for “pairs trading” through the ASX have opened up for retail investors. The Bear Fund offers the opportunity for investors to hedge out “market risk” while simultaneously betting on the relative outperformance of their preferred sector or stock.
For example, say you were bullish on the prospects for the Australian resources sector in general – or even an individual stock such as BHP – but were worried the overall market was at risk of decline. You might decide to invest 50% of funds allocated for this strategy into BHP or even a Resources Sector ETF. The remaining 50% could be invested in the BetaShares Bear Fund. Structured in this way, the investment should pay-off if the market overall declines – provided BHP or the Resources sector has gone up (you may even still be ahead if it does not go up or goes down by less than the overall market decline). Note, moreover, the Bear Fund is structured to even earn a small net-interest holding return broadly equal to the overnight wholesale interest rate less the Fund’s management costs of 1.38%p.a. – which helps to partly offset the opportunity cost for investors of tying-up their funds with this hedge.
With the advent of the Bear Fund, investors are now able to stake out positions in individual stocks or broad industry sectors (eg through ETFs), while reducing the risk of their investment coming unstuck by broader market declines. Investors can now access a simple to use method of separating company or sector risk from that of the market as a whole.