The structural tracking error minimization (STEM) approach produces stable tracking portfolios out-of-sample in the crucial investment period. Full version:
Today, the investment into indices has become a widely used strategy in portfolio management. While Index Funds and ETFs try to represent the performance of a single index, other portfolio strategies use indices as portfolio components to concentrate on the allocation task. Because an index cannot be purchased directly, it has to be rebuilt. This is called index tracking.
In today’s Portfolio Management many strategies are based on the investment into indices. This is a consequence of various empirical studies that show that the allocation over asset classes, countries etc. provides a greater performance contribution than the selection of single assets. For every portfolio containing indices as components the problem is that an index cannot be purchased directly. So it has to be rebuilt. This is called index tracking. The goal is to approximate the risk and return profile of an index.
At the present time, there is a major trend in the financial markets of focusing on the common factors rather than the individual characteristics of assets. The reason for this growth in popularity is that the portfolios, which replicate the performance of the indices, simplify the investment process and, at the same time, act as building blocks that can be used to construct larger investment portfolios that meet the objectives of investors.