Cointegrated market-neutral strategy for basket trading

Cointegration among two or more variables can be found in many economic or financial data. A typical application is to form portfolios based on the cointegrated relationships found in a set of financial assets in an attempt to generate profits. However, some high-net worth investors may find these portfolios too risky, particularly during a bear market, and hence they lose interest in adopting them in their trading strategies. A plausible method to relieve such burden to the investors is to construct a cointegrated portfolio which is also market-neutral. We name such cointegrated market-neutral portfolio as COINMAN. In this paper, we will tackle the problem of identifying COINMAN. We will discuss how to determine the number of COINMAN portfolios available among a set of assets. Finally, we apply the proposed methodology to identify COINMAN portfolios consisting of the constituent stocks of Hang Seng Index and Hang Seng China-Affiliated Corporations Index in Hong Kong. Our empirical results demonstrate that the trading strategies based on COINMAN portfolios are more profitable and less sensitive to the market than their cointegrated counterparts. Copyright © 2017 Elsevier Inc. All rights reserved.