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Factor Based Index Trading

Author

Listed:
  • Francesco Corielli
  • Massimiliano Marcellino

Abstract

Index tracking requires to build a portfolio of stocks (a replica) whose behavior 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.

Suggested Citation

  • Francesco Corielli & Massimiliano Marcellino, "undated". "Factor Based Index Trading," Working Papers 209, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
  • Handle: RePEc:igi:igierp:209
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    File URL: ftp://ftp.igier.uni-bocconi.it/wp/2002/209.pdf
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    References listed on IDEAS

    as
    1. Robert S. Pindyck & Julio J. Rotemberg, 1993. "The Comovement of Stock Prices," The Quarterly Journal of Economics, Oxford University Press, vol. 108(4), pages 1073-1104.
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    8. Mario Forni & Marc Hallin & Marco Lippi & Lucrezia Reichlin, 2000. "The Generalized Dynamic-Factor Model: Identification And Estimation," The Review of Economics and Statistics, MIT Press, vol. 82(4), pages 540-554, November.
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    10. Stock, James H & Watson, Mark W, 2002. "Macroeconomic Forecasting Using Diffusion Indexes," Journal of Business & Economic Statistics, American Statistical Association, vol. 20(2), pages 147-162, April.
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    12. James H. Stock & Mark W. Watson, 1998. "Diffusion Indexes," NBER Working Papers 6702, National Bureau of Economic Research, Inc.
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    Citations

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    Cited by:

    1. Forni, Mario & Hallin, Marc & Lippi, Marco & Zaffaroni, Paolo, 2015. "Dynamic factor models with infinite-dimensional factor spaces: One-sided representations," Journal of Econometrics, Elsevier, vol. 185(2), pages 359-371.
    2. Liang-chuan Wu & I-chan Tsai, 2014. "Three fuzzy goal programming models for index portfolios," Journal of the Operational Research Society, Palgrave Macmillan;The OR Society, vol. 65(8), pages 1155-1169, August.
    3. Blitz, David & Huij, Joop, 2012. "Evaluating the performance of global emerging markets equity exchange-traded funds," Emerging Markets Review, Elsevier, vol. 13(2), pages 149-158.
    4. Cavicchioli, Maddalena & Forni, Mario & Lippi, Marco & Zaffaroni, Paolo, 2016. "Eigenvalue Ratio Estimators for the Number of Common Factors," CEPR Discussion Papers 11440, C.E.P.R. Discussion Papers.
    5. Mario Forni & Marc Hallin & Marco Lippi & Paolo Zaffaroni, 2011. "One-Sided Representations of Generalized Dynamic Factor Models," EIEF Working Papers Series 1106, Einaudi Institute for Economics and Finance (EIEF), revised Mar 2011.
    6. Derigs, Ulrich & Marzban, Shehab, 2009. "New strategies and a new paradigm for Shariah-compliant portfolio optimization," Journal of Banking & Finance, Elsevier, vol. 33(6), pages 1166-1176, June.
    7. repec:eee:ecofin:v:42:y:2017:i:c:p:172-192 is not listed on IDEAS
    8. Boldin, Michael & Cici, Gjergji, 2010. "The index fund rationality paradox," Journal of Banking & Finance, Elsevier, vol. 34(1), pages 33-43, January.
    9. repec:eee:finana:v:54:y:2017:i:c:p:159-175 is not listed on IDEAS
    10. Canakgoz, N.A. & Beasley, J.E., 2009. "Mixed-integer programming approaches for index tracking and enhanced indexation," European Journal of Operational Research, Elsevier, vol. 196(1), pages 384-399, July.

    More about this item

    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 Prediction Models; Simulation Methods
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)

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