Abstract
Enhanced indexation is an active portfolio management strategy aimed to find a portfolio outperforming a market index. To ensure stable returns and to avoid extreme losses, a sensible enhanced indexation model should be sustainable, where the parameters of the model should be adjusted adaptively according to the market environment. Hence, in this paper, we propose a novel sustainable regime-based cardinality constrained enhanced indexation (RCEI) model, where different benchmarks and cardinalities can be imposed under different market regimes. By using historical observations, the RCEI model is transformed into a deterministic optimization problem with an ℓ 0 norm constraint. We design a partial penalty method coupled with the proximal alternating direction method of multipliers (ADMM) to solve the deterministic optimization problem. Numerical results in UK and US financial markets confirm the superb performance of the sustainability-oriented RCEI model and the efficiency of the algorithm.
Highlights
As the global financial market is riddled with more and more uncertainty, there is a growing awareness of incorporating sustainability-relates insights into investment analysis and management; investors boost their chances for long-term and sustainable success
For each week in the out-of-sample period, we find the optimal portfolio from the regime-based cardinality constrained enhanced indexation (RCEI) model with the historical data in the last 50 weeks before the week
We propose a new sustainability-oriented enhanced indexation model with regime switching and cardinality constraint
Summary
As the global financial market is riddled with more and more uncertainty, there is a growing awareness of incorporating sustainability-relates insights into investment analysis and management; investors boost their chances for long-term and sustainable success. Dose and Cincotti [9] sought a relatively high excess return within a reduced tracking error by adopting the historical look-back approach They solved the problem in a two-step heuristic method, while this method could not ensure the global optimality of the obtained portfolios. On account of the growing uncertainty in financial markets, we introduce a novel sustainability-oriented enhanced indexation model with the regime switching technique to avoid the extreme losses in the long-term assets management process, with the purpose of reflecting the fluctuations of the financial market timely and obtaining the sustainable investment profits. The paper is organized as follows: in Section 2, we establish the sustainable stochastic enhanced indexation model with regime switching and cardinality constraint, and transform the formulation by using historical observations.
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