Factor Based Index Tracking

Massimiliano Marcellino and Francesco Corielli ()

No 3265, CEPR Discussion Papers from C.E.P.R. Discussion Papers

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.

Keywords: Index tracing; Replica; Stock index; Factor models (search for similar items in EconPapers)
JEL-codes: C43 C53 G10 (search for similar items in EconPapers)
Date: 2002-03
New Economics Papers: this item is included in nep-cfn
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Citations: View citations in EconPapers (1)

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Related works:
Journal Article: Factor based index tracking (2006)
Working Paper: Factor Based Index Trading
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