Factor replication with industry stratification

Surpreet Bharjana, Rohan Fletcher, Paul Lajbcygier

Research output: Contribution to journalArticleResearchpeer-review

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 languageEnglish
Pages (from-to)118-135
Number of pages18
JournalFinancial Analysts Journal
Volume79
Issue number3
DOIs
Publication statusPublished - 2023

Keywords

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

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