Tuesday, December 29, 2009

A note on index tracking

A couple of years ago, Ernie has started an interesting discussion on his blog. A reader named 'L' was having doubts about ability of a small portfolio to track an index out of sample. And to be honest, he has a point, starting with only one stock in the portfolio you are most likely to get a random walk instead of tracking. On the other hand, having N-1 stocks in the portfolio should result in almost perfect tracking.
I've decided to verify the results and test tracking portfolios for the XLE. The results for 5 'best' portfolios consisting of only 5 stocks are given below.

Blue charts are in-sample training and red is true out-of-sample data (no re-balancing). Look how well three of them survived the 2008 debacles.
I must note that these portfolios have probably not enough variance for profitable trading, but that should be easy to fix.

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