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The Cointegration Alpha: Enhanced Index Tracking and Long-Short Equity Market Neutral Strategies


Carol Alexander


University of Sussex - School of Business, Management and Economics

Anca Dimitriu


University of Reading - ISMA Centre

June 2002

ISMA Finance Discussion Paper No. 2002-08

Abstract:     
This paper presents several applications of cointegration based trading strategies: a classic index tracking strategy, a long-short equity market neutral strategy and a number of strategies combining index tracking and long-short market neutral. 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. The combinations of index tracking and long-short market neutral are designed as to enhance the properties of the basic strategies.

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 produced 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.

Number of Pages in PDF File: 55

Keywords: cointegration, enhanced index tracking, long-short equity, market neutral, hedge fund, alpha strategy

JEL Classification: C32, C51, G11, G23

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Date posted: August 5, 2002  

Suggested Citation

Alexander, Carol and Dimitriu, Anca, The Cointegration Alpha: Enhanced Index Tracking and Long-Short Equity Market Neutral Strategies (June 2002). ISMA Finance Discussion Paper No. 2002-08. Available at SSRN: http://ssrn.com/abstract=315619 or http://dx.doi.org/10.2139/ssrn.315619

Contact Information

Carol Alexander (Contact Author)
University of Sussex - School of Business, Management and Economics ( email )
Falmer, Brighton BN1 9SL
United Kingdom
HOME PAGE: http://www.sussex.ac.uk/bam
Anca Dimitriu
University of Reading - ISMA Centre ( email )
Whiteknights Park
P.O. Box 242
Reading RG6 6BA
United Kingdom
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