Follow the Leader: Index Tracking with Factor Models

28 Pages Posted: 24 Jun 2019 Last revised: 6 Nov 2020

See all articles by Pan Jiang

Pan Jiang

Wilfrid Laurier University - Department of Business

Marcos Fabricio Perez

Wilfrid Laurier University - School of Business & Economics

Date Written: September 18, 2020

Abstract

We propose a new methodology to select a subset of assets for (partial) index replication, based on the latest research on factor models of large dimensions. Our method selects the set of leader stocks that can fully capture the systematic risk of the index to be replicated. Our selection methodology is consistent as the sample size and the number of assets jointly approach infinity. Monte Carlo experiments show that our estimated index replica tracks the underlying index with relatively small tracking errors in finite samples. We show the applicability of the method by tracking the S&P 500 equally weighed index with promising out-of-sample performance. Our method can be easily adapted for synthetic index replication and to incorporate measures of liquidity or transaction cost.

Keywords: Systematic risk; Index tracking; Passive fund Management; Factor models

JEL Classification: G00, G11, G23,C58, C55, C33, C38

Suggested Citation

Jiang, Pan and Perez, Marcos Fabricio, Follow the Leader: Index Tracking with Factor Models (September 18, 2020). Available at SSRN: https://ssrn.com/abstract=3406071 or http://dx.doi.org/10.2139/ssrn.3406071

Pan Jiang

Wilfrid Laurier University - Department of Business ( email )

Canada

Marcos Fabricio Perez (Contact Author)

Wilfrid Laurier University - School of Business & Economics ( email )

Waterloo, Ontario N2L 3C5
CANADA
519-884 0710 (Phone)
519-884 0201 (Fax)

HOME PAGE: http://www.public.asu.edu/~mfperez/

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