Sample Size and Tracking Error
1. Download data for last 3 years for the DJIA (Dow Jones Industrial Average) and each of the 30 component stocks. Download data from an appropriate financial website such as Google Finance, Yahoo Finance, Quandl, CityFALCON, or another similar source. If you are using the R language, then there are videos in the “Supplemental Videos in R” located in the “Supplemental Materials” at the bottom of the course ware on how to import CSV files into your program.
2. Calculate Monthly returns of the DJIA index and the downloaded stocks over the period under study
3. Calculate mean and standard deviation of monthly returns for the DJIA index
4. Choose an equal weighted portfolio consisting of any 5 random stocks from the DJIA, calculate the mean monthly returns and its standard deviation. Do the same for portfolios of 10,15, 20 and 25 random stocks from the DJIA universe.
5. Calculate tracking errors for each of the portfolios i.e. the margin by which the mean and standard deviation of the portfolio returns diverge from those of DJIA .
6. Graphically represent the tracking error for returns and risk (standard deviation of returns used as a proxy for risk) on y-axis against the sample size of portfolio on the x-axis.
Based on the results of your findings, complete the following analysis:
1. What all factors account for the tracking error of the constructed portfolios?
2. What is the relationship between tracking error and portfolio sample size?
3. What might be the most optimal way to decrease tracking error without having to construct a full portfolio matching the entire index
NB: Make use of R package or Excel.