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Factor Based Index Tracking

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  • Corielli, Francesco
  • Marcellino, Massimiliano

Abstract

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.

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Date of creation: Mar 2002
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Handle: RePEc:cpr:ceprdp:3265

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Keywords: factor models; index tracing; replica; stock index;

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References

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  1. Forni, Mario & Reichlin, Lucrezia, 1995. "Let's Get Real: A Dynamic Factor Analytical Approach to Disaggregated Business Cycle," CEPR Discussion Papers, C.E.P.R. Discussion Papers 1244, C.E.P.R. Discussion Papers.
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  12. Michael P. Clements & David F. Hendry, 2001. "Forecasting Non-Stationary Economic Time Series," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262531895, December.
  13. Beasley, J. E. & Meade, N. & Chang, T. -J., 2003. "An evolutionary heuristic for the index tracking problem," European Journal of Operational Research, Elsevier, Elsevier, vol. 148(3), pages 621-643, August.
  14. Rudolf, Markus & Wolter, Hans-Jurgen & Zimmermann, Heinz, 1999. "A linear model for tracking error minimization," Journal of Banking & Finance, Elsevier, vol. 23(1), pages 85-103, January.
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Cited by:
  1. Boldin, Michael & Cici, Gjergji, 2010. "The index fund rationality paradox," Journal of Banking & Finance, Elsevier, vol. 34(1), pages 33-43, January.
  2. Blitz, David & Huij, Joop, 2012. "Evaluating the performance of global emerging markets equity exchange-traded funds," Emerging Markets Review, Elsevier, Elsevier, vol. 13(2), pages 149-158.
  3. Mario Forni & Marc Hallin & Marco Lippi & Paolo Zaffaroni, 2011. "One-Sided Representations of Generalized Dynamic Factor Models," Working Papers ECARES, ULB -- Universite Libre de Bruxelles ECARES 2011-019, ULB -- Universite Libre de Bruxelles.
  4. Canakgoz, N.A. & Beasley, J.E., 2009. "Mixed-integer programming approaches for index tracking and enhanced indexation," European Journal of Operational Research, Elsevier, Elsevier, vol. 196(1), pages 384-399, July.

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