Factor Replication with Industry Stratification

Factor Replication with Industry Stratification

Factor investing exploits asset pricing anomalies to enhance fund returns. Unlike traditional market capitalization indexes, factors have onerous replication costs. We consider the impact of omitting costly, small stocks by industry in stratified factor-replicating portfolios. Such industry stratifi...

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Bibliographic Details
Published in:Financial analysts journal Vol. 79; no. 3; pp. 118 - 135
Main Authors: Bharjana, Surpreet, Fletcher, Rohan, Lajbcygier, Paul
Format: Journal Article
Language:English
Published: Charlottesville Routledge 03-07-2023
Taylor & Francis Ltd
Subjects:
Asset pricing
Benchmark fidelity
cost reduction
dynamic replication
factor indexation
factor replication
industry stratification
portfolio costs
Portfolios
Stratification
Tracking
tracking error
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Summary:Factor investing exploits asset pricing anomalies to enhance fund returns. Unlike traditional market capitalization indexes, factors have onerous replication costs. We consider the impact of omitting costly, small stocks by industry in stratified factor-replicating portfolios. Such industry stratification achieves broader industry coverage and lowers tracking error compared with competing approaches. We show that the improvement in tracking error is due to enhanced industry coverage, not risk exposure, resulting in substantial economic benefits.
ISSN:0015-198X
1938-3312
DOI:10.1080/0015198X.2023.2215252