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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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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Abstract	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.
AbstractList	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.
Author	Lajbcygier, Paul Bharjana, Surpreet Fletcher, Rohan
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Copyright	2023 CFA Institute. All rights reserved. 2023 2023 The Author(s). Published with license by Taylor & Francis Group, LLC. This work is licensed under the Creative Commons Attribution – Non-Commercial – No Derivatives License http://creativecommons.org/licenses/by-nc-nd/4.0/ (the “License”). Notwithstanding the ProQuest Terms and Conditions, you may use this content in accordance with the terms of the License.
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SubjectTerms	Asset pricing Benchmark fidelity cost reduction dynamic replication factor indexation factor replication industry stratification portfolio costs Portfolios Stratification Tracking tracking error
Title	Factor Replication with Industry Stratification
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