Mimicking Anything with ETFs

Can a simple set of exchange-traded funds (ETF), weighted judiciously, mimic the behaviors of most financial assets? In their January 2018 paper entitled “Mimicking Portfolios”, Richard Roll and Akshay Srivastava present and test a way of constructing mimicking portfolios using a small set of ETFs as investment factor proxies. They define a mimicking portfolio as a weighted set of tradable assets that match factor sensitivities of a target, which may be a specific asset, a fund or a non-tradable variable such as an economic indicator. They state that mimicking portfolios should: (1) consist of liquid, easily tradable assets; and, (2) exhibit little return volatility not explained by the factors used. They first winnow a large number of potential factor proxy ETFs spanning major asset classes and geopolitical regions by retaining only one ETF from any pair with daily return correlation greater than 0.70. They begin mimicking portfolio tests at the end of January 2009, when enough reasonably unique ETFs become available. They test this set of ETFs by creating portfolios from them that mimic each NYSE stock that has daily returns over the full sample period. Specifically, on the last day of each month, they reform a mimicking portfolio for each stock via a regression of stock return versus factor proxy ETF returns over the prior 300 trading days (or as few as 250 if 300 are not yet available) to reset coefficients for the ETFs. They perform an ancillary test by attempting to mimic iShares iBoxx $ Investment Grade Corporate Bond (LQD) and SPDR Dow Jones International Real Estate (RWX) ETFs, which are not in the factor proxy set. Using daily returns for the large number of ETFs and 1,634 NYSE stocks from the end of January 2009 through December 2016, they find that: (more…)