Equity Valuation and Portfolio Management

CHAPTER 21

Statistical Arbitrage

Brian J. Jacobsen, Ph.D., J.D., CFA, CFP®

Chief Portfolio Strategist Wells Fargo Funds Management, LLC and Associate Professor Wisconsin Lutheran College

A mantra of investing is, “Buy low and sell high.” If one can simultaneously execute both sides of the transaction—the buying and the selling—without any commitment of capital, pure arbitrage exists (also known as riskless arbitrage). The activity of arbitrage tends to be self-exhausting: buying a lower priced good creates demand for it and drives up its price; while selling a higher priced good increases supply and drives down its price.

Why add “statistical” to arbitrage? Because statistical arbitrage relationships are much more prevalent than pure arbitrage opportunities. Statistical arbitrage strategies are based on the idea that we do not know with certainty what the future holds; so we can only make probabilistic statements about what may occur. Statistical arbitrage also refers to the use of statistics in identifying arbitrage opportunities.

Statistical arbitrage strategies are subject to myriad risks, but the most important one is model risk. Model risk refers to whether or not a model of the price process of a security is accurate (i.e., whether it conforms to reality). With an accurate model of security pricing, the identification and exploitation of statistical arbitrage opportunities becomes a relatively easy task. Making sure those models are indeed accurate is the golden key to investing. ...