Advances and Applications in Statistics
Volume 53, Issue 3, Pages 243 - 258
(September 2018) http://dx.doi.org/10.17654/AS053030243 |
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ENHANCED INDEX TRACKING MODEL WITH ENTROPY MAXIMIZATION
Lam Weng Siew, Saiful Hafizah Jaaman and Lam Weng Hoe
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Abstract: The tracking of index is a branch in portfolio management that aims to construct an optimal portfolio in order to achieve comparable return to its benchmark index return by minimizing the active risk or tracking error. The objective of enhanced index tracking is to generate higher portfolio return than the returns of the benchmark index while minimizing the tracking error. Past studies did not consider entropy maximization in constructing the optimal portfolio to track the benchmark index return. Therefore, the objective of this study is to propose an enhanced index tracking model which improves the existing index tracking model and incorporates entropy maximization in order to generate a well diversified portfolio. The optimal portfolio compositions and portfolio performances of the proposed enhanced index tracking model and the existing index tracking model are compared and detailed in this paper. This study employs the weekly return of component stocks data of the FTSE Bursa Malaysia Kuala Lumpur Composite Index (FBMKLCI). The results of this study demonstrate that the proposed enhanced index tracking model is able to generate a well diversified optimal portfolio which outperforms the benchmark FBMKLCI index obtaining higher portfolio mean return without having to purchase all of the index components. The proposed enhanced index tracking model is also able to outperform the existing index tracking model to track the benchmark FBMKLCI Index in Malaysia. |
Keywords and phrases: entropy maximization, tracking error, optimal portfolio, efficient diversification. |
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