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Modifying Sequential Monte Carlo Optimisation for Index Tracking to Allow for Transaction Costs

Author

Listed:
  • Leila Hamilton-Russell

    (The African Institute of Financial Markets and Risk Management (AIFMRM), University of Cape Town, Cape Town 7701, South Africa)

  • Thomas Malan O’Callaghan

    (The African Institute of Financial Markets and Risk Management (AIFMRM), University of Cape Town, Cape Town 7701, South Africa)

  • Dmitrii Savin

    (Department of Mathematics, University College London, Gower Street, London WC1E 6BT, UK)

  • Erik Schlögl

    (The African Institute of Financial Markets and Risk Management (AIFMRM), University of Cape Town, Cape Town 7701, South Africa
    School of Mathematical and Physical Sciences, University of Technology Sydney, Ultimo, NSW 2007, Australia
    Faculty of Science, Department of Statistics, University of Johannesburg, Johannesburg 2006, South Africa)

Abstract

Managing a portfolio whose value closely tracks an index by trading only in a subset of the index constituents involves an NP-hard optimisation problem. In the prior literature, it has been suggested that this problem be solved using sequential Monte Carlo (SMC, also known as particle filter) methods. However, this literature does not take transaction costs into account, although transaction costs are the primary motivation for attempting to replicate the index by trading in a subset, rather than the full set of index constituents. This paper modifies the SMC approach to index tracking to allow for proportional transaction costs and implements this extended method on empirical data for a variety stock indices. In addition to providing a more practically useful tracking strategy by allowing for transaction costs, we find that including a penalty for transaction costs in the optimisation objective can actually lead to better tracking performance.

Suggested Citation

  • Leila Hamilton-Russell & Thomas Malan O’Callaghan & Dmitrii Savin & Erik Schlögl, 2024. "Modifying Sequential Monte Carlo Optimisation for Index Tracking to Allow for Transaction Costs," Risks, MDPI, vol. 12(10), pages 1-44, September.
    • Handle: RePEc:gam:jrisks:v:12:y:2024:i:10:p:155-:d:1489561
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    References listed on IDEAS

    as
    1. Johannes Ruf & Kangjianan Xie, 2019. "The impact of proportional transaction costs on systematically generated portfolios," Papers 1904.08925, arXiv.org.
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