Linear programming models based on Omega ratio for the Enhanced Index Tracking Problem

•We model the enhanced index tracking problem based on the Omega ratio.•We introduce two nonlinear mathematical formulations.•We show how each formulation can be transformed into a linear programming model.•We extend the models to include real features.•We show the very satisfactory out-of-sample performance of the optimal portfolios.

Modern performance measures differ from the classical ones since they assess the performance against a benchmark and usually account for asymmetry in return distributions. The Omega ratio is one of these measures. Until recently, limited research has addressed the optimization of the Omega ratio since it has been thought to be computationally intractable. The Enhanced Index Tracking Problem (EITP) is the problem of selecting a portfolio of securities able to outperform a market index while bearing a limited additional risk. In this paper, we propose two novel mathematical formulations for the EITP based on the Omega ratio. The first formulation applies a standard definition of the Omega ratio where it is computed with respect to a given value, whereas the second formulation considers the Omega ratio with respect to a random target. We show how each formulation, nonlinear in nature, can be transformed into a Linear Programming model. We further extend the models to include real features, such as a cardinality constraint and buy-in thresholds on the investments, obtaining Mixed Integer Linear Programming problems. Computational results conducted on a large set of benchmark instances show that the portfolios selected by the model assuming a standard definition of the Omega ratio are consistently outperformed, in terms of out-of-sample performance, by those obtained solving the model that considers a random target. Furthermore, in most of the instances the portfolios optimized with the latter model mimic very closely the behavior of the benchmark over the out-of-sample period, while yielding, sometimes, significantly larger returns.