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

Carol Alexander and Anca Dimitriu ()
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Anca Dimitriu: ICMA Centre, University of Reading

ICMA Centre Discussion Papers in Finance from Henley Business School, 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

Keywords: cointegration; tracking error; index tracking; statistical arbitrage (search for similar items in EconPapers)
JEL-codes: C32 C51 G11 G23 (search for similar items in EconPapers)
Pages: 26 pages
Date: 2004-03
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Citations: View citations in EconPapers (3)

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