On the application of cointegration analysis in enhanced indexing

Abstract

We investigate the application of cointegration techniques in designing trading portfolios that outperform a market benchmark. Of particular interest is the situation of enhanced indexation with incomplete portfolios, that is, by imposing a limit on the maximum number of assets included in the portfolio. We present a technique for solving cardinality-constrained portfolio selection problems using cointegration analysis. We investigate the empirical performance of cointegration-based trading strategies in the context of benchmarking portfolios relative to a common stock market index.

Keywords:

• enhanced indexation
• long–short market-neutral strategies
• cointegration
• cardinality constraints

JEL Classification:

• C22
• C61

Notes

¹ See Alexander and Dimitriu (2005, pp. 53–4), for more details on this technique.

² Data were downloaded from Yahoo! Finance on 12 November 2008.