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A Comparison of Cointegration & Tracking Error Models for Mutual Funds & Hedge Funds

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Author Info

  • Carol Alexander

    ()
    (ICMA Centre, University of Reading)

  • Anca Dimitriu

    ()
    (ICMA Centre, University of Reading)

Abstract

We present a detailed study of portfolio optimisation based on cointegration, a statistical tool that here exploits a long-run equilibrium relationship between stock prices and an index price. We compare the theoretical and empirical properties of cointegration optimal equity portfolios with those of portfolios optimised on the tracking error variance. From an eleven year out of sample performance analysis we find that for simple index tracking the additional feature of cointegration between the tracking portfolio and the index has no clear advantages or disadvantages relative to the tracking error variance (TEV) minimization model. However ensuring a cointegration relationship does pay off when the tracking task becomes more difficult. Cointegration optimal portfolios clearly dominate the TEV equivalents for all of the statistical arbitrage strategies based on enhanced indexation, in all market circumstances

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Bibliographic Info

Paper provided by Henley Business School, Reading University in its series ICMA Centre Discussion Papers in Finance with number icma-dp2004-03.

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Length: 26 pages
Date of creation: Mar 2004
Date of revision:
Handle: RePEc:rdg:icmadp:icma-dp2004-03

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Related research

Keywords: cointegration; tracking error; index tracking; statistical arbitrage;

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Cited by:
  1. Roßbach, Peter & Karlow, Denis, 2011. "The stability of traditional measures of index tracking quality," Frankfurt School - Working Paper Series 164, Frankfurt School of Finance and Management.
  2. Sergio Mayordomo & Juan Ignacio Peña & Juan Romo, 2009. "Are There Arbitrage Opportunities in Credit Derivatives Markets? A New Test and an Application to the Case of CDS and ASPs," Business Economics Working Papers wb096303, Universidad Carlos III, Departamento de Economía de la Empresa.

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