Index tracking requires building a portfolio of stocks (a replica) whose behaviour is as close as possible to that of a given stock index. Typically, much fewer stocks should appear in the replica than in the index, and there should be no low frequency (persistent) components in the tracking error. Unfortunately, the latter property is not satisfied by many commonly used methods for index tracking. These are based on the in-sample minimization of a loss function, but do not take into account the dynamic properties of the index components. Instead, we represent the index components with a dynamic factor model, and develop a procedure that, in a first step, builds a replica that is driven by the same persistent factors as the index. In a second step, it is also possible to refine the replica so that it minimizes a loss function, as in the traditional approach. Both Monte Carlo simulations and an application to the EuroStoxx50 index provide substantial support for our approach.
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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number
3265.
Francesco Corielli & Massimiliano Marcellino, .
"Factor Based Index Trading,"
Working Papers
209, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
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Find related papers by JEL classification: C43 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: Special Topics - - - Index Numbers and Aggregation C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Other Model Applications G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
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References listed on IDEAS Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
James H. Stock & Mark W. Watson, 1998.
"Diffusion Indexes,"
NBER Working Papers
6702, National Bureau of Economic Research, Inc.
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