Constrained Index Tracking under Loss Aversion Using Differential Evolution

Index tracking is concerned with forming a portfolio that mimics a benchmark index as closely as possible. Traditionally, this implies that the returns between the index and the portfolio should differ as little as possible. However, investors might happily accept positive deviations (ie, returns higher than the index’s) while being particularly concerned with negative deviations. In this chapter, we model these preferences by introducing loss aversion to the index tracking problem and analyze the financial implications based on a computational study for the US stock market. In order to cope with this demanding optimization problem, we use Differential Evolution and investigate some calibration issues.