Cointegration in Finance: An Application to Index Tracking

Abstract

The purpose of this paper is to construct and test two different index tracking strategies - one based upon cointegration analysis of the price processes of assets (CIT strategy), and the other based on a market equilibrium and continuous time portfolio optimisation approach (MIT strategy). Within a broad empirical analysis it is found that both tracking strategies are able to track an index (FTSE100, DJ Industrial, DJ Composite Average) accurately, even if only a relatively small subset of constituent stocks is used. Thereby, it is also suggested that (particularly in the British stock market) the CIT strategy is preferred since there is some (out of sample) evidence indicating that log-price spreads between index and CIT tracking portfolio follow a stationary process. Moreover, regarding the attempt to perform simple enhanced indexation, no empirical evidence was found that would suggest that either of the two tracking strategies was suitable for such an approach.

Keywords: index tracking, enhanced indexation, cointegration, portfolio optimization, tracking error minimization