Are pairs trading profits robust to trading costs?

We examine the impact of trading costs on pairs trading profitability in the U.S. equity market, 1963 to 2009. After controlling for commissions, market impact, and short selling fees, pairs trading remains profitable, albeit at much more modest levels. Specifically, we document a risk-adjusted return of about 30 basis points per month among portfolios of well-matched pairs that are formed within refined industry groups. Pairs trading exhibits a lower risk and lower return profile than a short-term reversal strategy that sorts stocks relative to their industry peers. Notably, both these types of contrarian investing are largely unprofitable after 2002.