Benchmark Replication Portfolio Strategies

Abstract

We propose a novel approach to the benchmark replication problem which uses a minimum tracking error variance as an objective subject to a target expected outperformance. When no budget constraint is imposed on the replicating portfolio, the solution involves that standard hedge portfolio and the tangent portfolio constructed from the replicating securities. In the presence of a budget constraint as well, the solution also includes the minimum variance portfolio constructed from the replicating securities. We implement our theoretical results using recent data for three widely followed US stock indices with very good out-of-sample performance.