Cointegration portfolios of European equities for index tracking and market neutral strategies

Traditional quantitative portfolio construction relies on the analysis of correlations between assets. Over the last ten years, following the generalised use of the JP Morgan RiskMetrics approach, quantitative portfolio managers have made increasing use of conditional correlations. If correlations are indeed time varying, their many changes unfortunately make them a difficult tool to use in practice when managing quantitative portfolios, as the frequent rebalancing they imply may be very costly. This paper uses the concept of cointegration which relies on the long-term relationship between time series, and thus assets, to devise quantitative European equities portfolios in the context of two applications: a classic index tracking strategy and a long/short equity market neutral strategy. Data are used from the Dow Jones EUROStoxx50 index and its constituent stocks from 4th January, 1999, to 30th June, 2003. The results show that the designed portfolios are strongly cointegrated with the benchmark and indeed demonstrate good tracking performance. In the same vein, the long/short market neutral strategy generates steady returns under adverse market circumstances but, contrary to expectations, does not minimise volatility.