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Sector leaders: the pair trade that wasn’t
Trading the two largest companies in each industry against each other adds nothing. Picking the one with the most upside among each industry’s five largest does: 20.6% a year, ahead of the S&P 500 in 8 of 11 years.
Leaders
Most upside of the top 520.6%
S&P 50015.7%
8 of 11 years ahead of the index
The question.
If you pair the two biggest companies of each sector and trade the gap between them, do you get paid? And if not, is there anything in sector leaders worth owning?
81%of pair variants did worse than simply buying both
−0.5%a year for the market-neutral version
20.6%a year for the most-upside pick, vs 15.7%
8 of 11years ahead of the S&P 500
How we tested it
1The pairsEvery month, the two largest companies by market cap in each of 12 sectors and 60 industry groups, point in time.
2The tradeThe ratio of the two, traded on its z-score, long-short and long-only, with and without the market regime.
3The test792 variants, trained on 2018–2022 and judged on 2023–2026, with 10 bp of costs and borrowing fees.
4The alternative208 more variants that pick inside each industry by valuation instead of trading the pair.
What we found.
| 2016 → 2026, monthly | CAGR | Sharpe | Worst drop |
|---|---|---|---|
| Most upside of each industry’s five largest (US) | 20.6% | 1.20 | −25.5% |
| Same idea, equal weights | 19.1% | 1.05 | −29.2% |
| S&P 500, with dividends | 15.7% | 1.05 | −23.9% |
- Between giants of the same sector, the gap does not come back. One pulls away and stays away, so the pair signal has nothing to trade.
- The market regime does not help: both regime filters lowered the Sharpe ratio.
- What works is selection, not hedging: inside each industry, the large company with the most upside to its target.
- Outside the United States it does not hold up.