Subset SSD for enhanced indexation with sector constraints

Abstract

In this paper we apply second order stochastic dominance (SSD) to the problem of enhanced indexation with asset subset (sector) constraints. The problem we consider is how to construct a portfolio that is designed to outperform a given market index whilst having regard to the proportion of the portfolio invested in distinct market sectors. In our approach, subset SSD, the portfolio associated with each sector is treated in a SSD manner. In other words in subset SSD we actively try to find sector portfolios that SSD dominate their respective sector indices. However the proportion of the overall portfolio invested in each sector is not pre-specified, rather it is decided via optimisation. Computational results are given for our approach as applied to the S\&P~500 over the period $29^{\text{th}}$ August 2018 to $29^{\text{th}}$ December 2023. This period, over 5 years, includes the Covid pandemic, which had a significant effect on stock prices. Our results indicate that the scaled version of our subset SSD approach significantly outperforms the S\&P~500 over the period considered. Our approach also outperforms the standard SSD based approach to the problem.