Factor Replication with Industry Stratification

Abstract

Abstract Factor investing exploits asset pricing anomalies to enhance fund returns. Unlike traditional market capitalization indexes, factors have onerous replication costs. We consider the impact of omitting costly, small stocks by industry in stratified factor-replicating portfolios. Such industry stratification achieves broader industry coverage and lowers tracking error compared with competing approaches. We show that the improvement in tracking error is due to enhanced industry coverage, not risk exposure, resulting in substantial economic benefits.