A Sustainability-Oriented Enhanced Indexation Model with Regime Switching and Cardinality Constraint

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.