<< Read Part I: Replicating Indexes In R With Style Analysis

Imitation, Oscar Wilde famously observed, “is the sincerest form of flattery that mediocrity can pay to greatness.” The observation echoes the objective for using Professor Bill Sharpe’s style analysis to replicate investment indexes that, for one reason or another, can’t be purchased directly. If we can obtain an index’s returns, there’s a pretty good chance that we can reverse engineer the asset allocation and recreate the portfolio with publicly traded securities.

Earlier this month I reviewed a simple example of index replication by using 11 sector ETFs to recreate the S&P 500. But that was child’s play, not to mention pointless from a practical standpoint since it’s easy to buy the S&P via ETFs and index mutual funds. The objective, however, was to illustrate the process via R code that I wrote.

Let’s try something more ambitious this time by attempting to replicate the Barclay Global Macro Index (BGMI), which aggregates the performances of dozens of funds in the niche. The index’s monthly returns are freely available so in theory, we can decompose the weights by performing regression analysis on the benchmark in context with a relevant set of securities that, overall, represent guesstimates for BGMI’s portfolio.

The challenge is that we don’t know what’s inside BGMI. Yes, we could subscribe to the database and see the funds, but that wouldn’t help since it’s unlikely that the underlying portfolios would be listed. The fact that the index is comprised of many individual global macro products makes our task especially difficult. Indeed, the global macro space covers a wide array of strategies across stocks, bonds, futures, and options and employs varying amounts of leverage while taking long and short positions. A professional-grade effort to replicate a benchmark that proxies for dozens of funds in this corner would require considerable effort beyond what’s attempted here. But let’s take a stab at a first approximation by making some general assumptions.