Portfolio Optimization

Unit 5: Index Tracking Model

Duan LI & Xiangyu Cui
India Institute of Technology Kharagpur
May 26 - 30, 2014

Market Setting

Outline

Market Setting
Tracking Error Minimization
Linear Programming Formulation

1 / 10

Market Setting

Market Setting

Let T be the number of observations and n be the number of

assets.

Y is a vector of continuously compounded benchmark returns,

which is a T dimensional vector.

X is the matrix of continuously compounded returns on n

assets, which is a T n matrix.

is the portfolio weights to be determined, which is an n

dimensional vector.

2 / 10

Tracking Error Minimization

Outline

Market Setting
Tracking Error Minimization
Linear Programming Formulation

3 / 10

Tracking Error Minimization

Minimization of Tracking Error Variance

The investor chooses the portfolio such that tacking error variance
is minimized,
min (Y X )0 (Y X ).
The optimal portfolio is :

= (X 0 X )

X 0Y .

4 / 10

Tracking Error Minimization

Minimization of Various Tracking Error

Functions
I

Mean absolute deviation (MAD):

min 10 (|X

MinMax:

min
I

max |Xt
t

Yt | .

Mean absolute downside deviation (MADD):

min 10 (min(X

Y |).

Downside MinMax (DMinMax):

min max (min(Xt

t

Y , 0)).

Yt , 0)) .

5 / 10

Linear Programming Formulation

Outline

Market Setting
Tracking Error Minimization
Linear Programming Formulation

6 / 10

Linear Programming Formulation

MAD
Let zt+ 0 be a positive deviation and zt
0 the absolute value
of a negative deviation between the portfolio and benchmark
returns. Then
Yt > 0 , Xt

Xt

zt = Yt ,

Yt < 0 , Xt + zt+ = Yt ,

Xt
which implies
min

zt+ ,

zt ,

s.t.

T
X

(zt+ + zt )

t=1

Xt + zt+
0

zt+

zt = Yt , t = 1, . . . , T ,

= 1,
0, zt

0, t = 1, . . . , T .
7 / 10

Linear Programming Formulation

MinMax
Let z

0 be an upper boundary of the absolute deviations:

Yt |, t = 1, . . . , T .

|Xt

z
We have
min z
z,

s.t. Xt

z Yt , t = 1, . . . , T ,

Xt + z
0

= 1,

0.

Yt , t = 1, . . . , T ,

8 / 10

Linear Programming Formulation

MADD
If investors are concerned about negative deviations between the
portfolio and the benchmark, the zt+ are dropped from the
optimization MAD, which results in
min

zt ,

T
X

zt

t=1

s.t. Xt + zt
0

zt

Yt , t = 1, . . . , T ,

= 1,
0, t = 1, . . . , T .

9 / 10

Linear Programming Formulation

DMinMax
Only the restrictions Xt Yt are relevant. Thus, we only care
about Xt + z Yt .
min z
z,

s.t. Xt + z
0

= 1,

0.

Yt , t = 1, . . . , T ,

10 / 10