Robust portfolio selection for index tracking

We develop a robust portfolio selection model for tracking a market index using a subset of its assets. The model is a 0–1 integer program that seeks to maximize similarity between selected assets and the assets of the target index. We allow uncertainty in the objective function by using a computationally tractable robust framework that can control the conservativeness of the solution. This protects against worst-case realizations of potential estimation errors and other deviations. Out-of-sample experiments using the S&P 100 demonstrate the advantages of the robust model. Compared to portfolios constructed with the nominal model, moderately conservative robust portfolios are shown to have lower tracking error and risk profiles that are more similar to the target index.