Factor replication with industry stratification

Surpreet Bharjana; Rohan Fletcher; Paul Lajbcygier

doi:10.1080/0015198X.2023.2215252

Factor replication with industry stratification

Surpreet Bharjana, Rohan Fletcher, Paul Lajbcygier

Research output: Contribution to journal › Article › Research › peer-review

2 Citations (Scopus)

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.

Original language	English
Pages (from-to)	118-135
Number of pages	18
Journal	Financial Analysts Journal
Volume	79
Issue number	3
DOIs	https://doi.org/10.1080/0015198X.2023.2215252
Publication status	Published - 2023

Keywords

Benchmark fidelity
cost reduction
dynamic replication
factor indexation
factor replication
industry stratification
portfolio costs
tracking error

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10.1080/0015198X.2023.2215252Licence: CC BY-NC-ND

572424359-oaFinal published version, 1.27 MBLicence: CC BY-NC-ND

Cite this

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title = "Factor replication with industry stratification",

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.",

keywords = "Benchmark fidelity, cost reduction, dynamic replication, factor indexation, factor replication, industry stratification, portfolio costs, tracking error",

author = "Surpreet Bharjana and Rohan Fletcher and Paul Lajbcygier",

note = "Funding Information: The authors would like to thank Charles Custeau and Nick Diamidis for research assistance. We dedicate this work to the memory of Dr. Neil Burgess and Dr. Andrew Sanford. Publisher Copyright: {\textcopyright} 2023 CFA Institute. All rights reserved.",

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AU - Fletcher, Rohan

AU - Lajbcygier, Paul

N1 - Funding Information: The authors would like to thank Charles Custeau and Nick Diamidis for research assistance. We dedicate this work to the memory of Dr. Neil Burgess and Dr. Andrew Sanford. Publisher Copyright: © 2023 CFA Institute. All rights reserved.

PY - 2023

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N2 - 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.

AB - 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.

KW - Benchmark fidelity

KW - cost reduction

KW - dynamic replication

KW - factor indexation

KW - factor replication

KW - industry stratification

KW - portfolio costs

KW - tracking error

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JO - Financial Analysts Journal

JF - Financial Analysts Journal

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ER -

Factor replication with industry stratification

Abstract

Keywords

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