Enhanced Indexation Based on Second-Order Stochastic Dominance

19 Pages Posted: 7 Mar 2011

See all articles by Diana Roman

Diana Roman

Brunel University London - School of Information Systems, Computing and Mathematics

Gautam Mitra

Brunel University London - CARISMA: The Centre for the Analysis of Risk and Optimisation Modelling Applications

Victor Zviarovich

Brunel University London

Date Written: March 4, 2011

Abstract

Second order Stochastic Dominance (SSD) has a well recognised importance in portfolio selection, since it provides a natural interpretation of the theory of risk-averse investor behaviour. Recently, SSD-based models of portfolio choice have been proposed; these assume that a reference distribution is available and a portfolio is constructed, whose return distribution dominates the reference distribution with respect to SSD. We present an empirical study which analyses the effectiveness of such strategies in the context of enhanced indexation. Several datasets, drawn from FTSE 100, SP 500 and Nikkei 225 are investigated through portfolio rebalancing and backtesting. Three main conclusions are drawn. First, the portfolios chosen by the SSD based models consistently outperformed the indices and the traditional index trackers. Secondly, the SSD based models do not require imposition of cardinality constraints since naturally a small number of stocks are selected. Thus, they do not present the computational difficulty normally associated with index tracking models. Finally, the SSD based models are robust with respect to small changes in the scenario set and little or no rebalancing is necessary. In this paper we present a unified framework which incorporates (a) SSD, (b) downside risk (Conditional Value-at-Risk) minimisation and (c) enhanced indexation.

Keywords: index tracking, enhanced indexation, stochastic dominance, backtesting

JEL Classification: D81, G14, C44, C61, C52, E44

Suggested Citation

Roman, Diana and Mitra, Gautam and Zviarovich, Victor, Enhanced Indexation Based on Second-Order Stochastic Dominance (March 4, 2011). Available at SSRN: https://ssrn.com/abstract=1776966 or http://dx.doi.org/10.2139/ssrn.1776966

Diana Roman (Contact Author)

Brunel University London - School of Information Systems, Computing and Mathematics ( email )

United Kingdom

Gautam Mitra

Brunel University London - CARISMA: The Centre for the Analysis of Risk and Optimisation Modelling Applications ( email )

John Crank Building
Brunel University
Uxbridge, UB8 3PH
United Kingdom

Victor Zviarovich

Brunel University London ( email )

Kingston Lane
Uxbridge, Middlesex UB8 3PH
United Kingdom

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