Report on Trades during week of Feb 21

HedgeFundLive
02-26-2011

Fuqua Team

Lead: Larry Levan

Neil Advani
Justin Andrews
Sadaf Hossain
Fusheng Li, MD,PhD
Lina Ren
Zidong Zhang, PhD
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Trading Report Feb21

Trades:

As mentioned in the previous report, one of our strategies going forward was experimenting with pairs
trading. There were two types of pairs under consideration:

1. Pair a company with its ETF sector. Hedge against events of individual companies by pairing it with a
respective ETF.
2. Find two sectors that would hedge each other-i.e. two sector ETFs.

First, we used our industry knowledge to gage potential companies or sectors that may have a reason to
outperform or underperform their ETF or work as a hedge to another sector. Concerning the hedging
side, this proved to be fairly difficult because as a whole, the health care sectors were trending up with
little presence of natural hedges. This meant that there seemed to be continued confidence in the
healthcare sector as a whole rather than if this sector was performing well, a corresponding sector would
not.

However, the only sector that showed negative growth over the past 3 months was pharma but it was
difficult to identify what pharma could potentially act as a hedge to on a sector basis. Due to this recent
negative growth in pharma though, we decided to go beyond sectors and into companies and hence
learning more to option #1 rather than #2 for the time being. To this end, we began looking at
pharmaceutical companies and their respective ETFs. Part of this strategy would be to look at historical
data of selected companies and compare them to their sector ETF to see how they correlated especially
given a history of company events and if there would be a potential pair.

We took a look at a quintessential pharma company, Pfizer, because of a long active history of events of
drug approvals and drug failures on which to compare the effect on its stock price and its correlation to
the ETF pharma sector. We also took a look at BristolMyers Squibb because it is a company that will
have an FDA ruling on a new drug soon. Below we will explain our methodology and some of the
limitations to this approach of trading.

Discussion on event-based trading strategy

As the next step, we try to gain exposure to single health care companies where we take bets on event
outcomes. To validate this idea, we did the following analysis on key assumptions.

Analysis on Events-Price-Spread relationship

For such a strategy to work, the following assumptions need to be true:

1. There are enough key events/news for us to bet on, for example drug approvals.
2. We can predict some of the event outcomes based on our health care knowledge.
3. The market interpretation of these event outcomes drives underlying stock price changes.
4. We can predict the direction of underlying stock price changes by interpreting how the market
views particular event outcomes.

To validate this event-based trading strategy, we chose to dig into historical data for Pfizer and BMS in
the past 20 months to examine assumption #3 and #4.

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Trading Report Feb21

As the above table shows, we took the key events featuring Pfizer in the past 20 months, and assigned
ratings on those events based on our interpretation on how market would react. The ratings range from -
10 to 20. Then we checked weekly Pfizer price changes given these events. In addition, to remove the
effects of industry wide factors and only focus on Pfizer, we also checked changes of Pfizer – PJP
spread, which is the difference between Pfizer and PJP(diversified Pharma ETF). The findings are:
1. The outcomes of these single events didn’t cause predictable changes in Pfizer’s stock price. As
the analysis shows, the weekly price changes are not correlated with rated events.
2. The outcomes of these single events didn’t cause predictable changes in Pfizer-PJP spread.
Again, low correlation observed between the event ratings and the spread we picked.

We did the same type of analysis using BMS and got similar results.

There are two possible explanations for this result:

1. Our interpretations, a.k.a. ratings, of the events are not accurate.
2. These events, among all factors that affect Pfizer’s price or spread with industry ETF, are not key
determinants. Given that Pfizer and BMS are both big and diversified, their stock price and
spread with its industry are even less correlated with single events.
The second explanation is more reasonable, and not surprising.

Implications:
The event-based trading strategy should be used with great caution. In most cases, it might not prove
useful. It might be more useful if the companies being traded are relatively smaller and less diversified;
hence the price would be more reactive to single events. It seems better to take bets on sectors than
single company events.

Going forward

We are in the process of setting up our own investment process, which include investment idea
generation, forecasting model, portfolio management, trade execution and risk management. Due to the

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Trading Report Feb21

somewhat inaccurate results of pairs event based trading, we decided to not make changes to our
portfolio until we can come up with a more accurate model to predict the outcomes of events.

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