Factor tracking: A new smart beta strategy that outperforms naïve diversification

Chonghui Jiang, Jiangze Du, Yunbi An and Jinqing Zhang

Economic Modelling, 2021, vol. 96, issue C, 396-408

Abstract: This paper proposes a factor tracking strategy that minimizes the variance of the difference in returns between a target portfolio and return-driving factors. We establish and solve single- and multi-factor tracking models, and analyze the properties of the optimal portfolios. We find that the optimal factor tracking portfolios consist of factor mimicking portfolios and the minimum-variance portfolio determined in the traditional mean-variance model. Moreover, we derive the condition under which the multi-factor tracking portfolio is a linear convex combination of the corresponding single-factor tracking portfolios. Using various datasets from the US market, we show that the factor tracking portfolios outperform the equally-weighted portfolio, measured by both risk and Sharpe ratio. The superior performance of the factor tracking portfolios are attributed to these portfolios’ better upside participation and downside protection.

Keywords: Multi-factor asset pricing model; Factor tracking portfolio; Minimum-variance portfolio; Naïve diversification (search for similar items in EconPapers)
Date: 2021
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:ecmode:v:96:y:2021:i:c:p:396-408

DOI: 10.1016/j.econmod.2020.03.023

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