The Cointegration Alpha: Enchanced Index Tracking and Long-Short Equity Market Neutral Stragies
This paper presents two applications of cointegration based trading strategies: a classic index tracking strategy and a long-short equity market neutral strategy. As opposed to other traditional index tracking or long-short equity strategies, the portfolio optimisation is based on cointegration rather than correlation. The first strategy aims to replicate a benchmark accurately in terms of returns and volatility, while the other seeks to minimise volatility and generate steady returns under all market circumstances. Additionally, several combinations of these two strategies are explored. To validate the applicability of the cointegration technique to asset allocation, pioneered by Lucas (1997) and Alexander (1999), and explain how and why it works, we have employed a panel data on DJIA and its constituent stocks. When applied to constructing trading strategies in the DJIA, the cointegration technique produces encouraging results. For example, between January 1995 and December 2001 the most successful self-financing statistical arbitrage strategies returned (net of transaction and repo costs) approximately 10% with roughly 2% annual volatility and negligible correlation with the market. The comprehensive set of back-test results reported is meant to offer a detailed picture of the cointegration mechanism, and to emphasise its practical implementation issues. Its key characteristics, i.e. mean reverting tracking error, enhanced weights stability and better use of the information contained in stock prices, allow a flexible design of various funded and self-financing trading strategies, from index and enhanced index tracking, to long-short market neutral and alpha transfer techniques. Further enhancement of the strategy should target first, the identification of successful stock selection rules to supplement the simple cointegration results and second, the investigation of the potential benefits of applying optimal rebalancing rules.
|Date of creation:||Apr 2002|
|Date of revision:|
|Contact details of provider:|| Postal: PO Box 218, Whiteknights, Reading, Berks, RG6 6AA|
Phone: +44 (0) 118 378 8226
Fax: +44 (0) 118 975 0236
Web page: http://www.henley.reading.ac.uk/
More information through EDIRC
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.:
- Francis X. Diebold & Javier Gardeazabal & Kamil Yilmaz, 1993.
"On cointegration and exchange rate dynamics,"
93-2, Federal Reserve Bank of Philadelphia.
- Baillie, Richard T & Bollerslev, Tim, 1994.
" Cointegration, Fractional Cointegration, and Exchange Rate Dynamics,"
Journal of Finance,
American Finance Association, vol. 49(2), pages 737-45, June.
- Baillie, R.T. & Bollerslev, T., 1993. "Cointegration, Fractional Cointegration, and Exchange RAte Dynamics," Papers 9103, Michigan State - Econometrics and Economic Theory.
- Engle, Robert & Granger, Clive, 2015.
"Co-integration and error correction: Representation, estimation, and testing,"
Publishing House "SINERGIA PRESS", vol. 39(3), pages 106-135.
- Engle, Robert F & Granger, Clive W J, 1987. "Co-integration and Error Correction: Representation, Estimation, and Testing," Econometrica, Econometric Society, vol. 55(2), pages 251-76, March.
- Baillie, Richard T & Bollerslev, Tim, 1989. " Common Stochastic Trends in a System of Exchange Rates," Journal of Finance, American Finance Association, vol. 44(1), pages 167-81, March.
When requesting a correction, please mention this item's handle: RePEc:rdg:icmadp:icma-dp2002-08. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Marie Pearson)
If references are entirely missing, you can add them using this form.