Mimicking Portfolios

Abstract

Mimicking portfolios have many applications in the practice of finance. A new method for constructing them is presented in this article. The authors illustrate its application by creating portfolios that mimic individual NYSE stocks. On the construction date, a mimicking portfolio exactly matches its target stock’s exposures (betas) to a set of exchange-traded funds, which serve as proxies for global factors. The portfolio has much lower idiosyncratic volatility than its target, and mimicking portfolios require only modest subsequent rebalancing in response to instabilities in target assets and assets used for portfolio construction. Although here composed exclusively of equities, mimicking portfolios show potential for mimicking non-equity assets as well.

TOPICS: Portfolio construction, analysis of individual factors/risk premia, exchange-traded funds and applications