Matching Portfolios by David Kane and Jeff Enos

“Matching” portfolios is a technique for generating a reasonable benchmark for determining the relative performance of a specific equity portfolio and is based on the work in Ho et al. (2005a). Consider the simplest case of a long-only mutual fund that has returned 10% in the last year. Has the portfolio done well? If the average stock in the universe has gone up 50% then, obviously, the portfolio has done poorly. If, on the other hand, the average stock has gone down 25%, then the portfolio has done remarkably well. In other words, it is impossible to evaluate the performance of a portfolio without considering the hypothetical performance of other possible portfolios. In this case, we are comparing the performance of our portfolio to that of a hypothetical portfolio that is equal-weighted all the stocks in the universe. But, depending on the characteristics of our mutual fund, this may not be a reasonable benchmark. Matching portfolios provide a benchmark which matches the characteristics — sector exposures, capitalization biases, position sizes — of the target portfolio. The portfolio package provides the matching method as a means of computing a matching portfolio. In this article we describe the intuition behind matching in general, frame a real-world problem in which computing a portfolio benchmark is difficult, and show how the matching facility of the portfolio package can be used to solve this problem.