Empirical Insights on Indexing : How Capitalization, Stratification and Weighting Can Affect Tracking Error

The focus of this study is the effect that portfolio composition has on the tracking performance of indexed portfolios. Indexed portfolios from high-capitalization indices are shown to have a lower tracking error and standard deviation of tracking error than indexed portfolios from low-capitalization indices. Additionally, the results indicate that value-weighted indices can be indexed more accurately than equally-weighted indices. Moreover, stratification across industry groups does not appear to be as important for forming a low-capitalization indexed portfolio as it is for forming a high-capitalization indexed portfolio. Finally, the rebalancing frequency of solving for the optimal portfolio weights for the stocks in the indexed portfolios does not appear to be critical factor affecting tracking performance