Subset second-order stochastic dominance for enhanced indexation with diversification enforced by sector constraints

TL;DR

This paper introduces a subset second-order stochastic dominance method for portfolio construction that enforces sector diversification and outperforms standard benchmarks on real market data.

Contribution

It develops a novel subset SSD approach that optimizes sector allocations to outperform indices, incorporating sector constraints via multivariate stochastic dominance.

Findings

Subset SSD outperforms the S&P500 in backtests.

Including sector constraints improves out-of-sample performance.

The method is effective on Fama-French industry data.

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. Our subset SSD approach involves the numeric solution of a multivariate second-order stochastic dominance problem. Computational results are given for our approach as applied to the S&P500 over the period 3rd October 2018 to 29th December 2023. This period, over 5 years, includes the Covid pandemic, which had a significant effect on stock prices. The S&P500 data that we have used is made publicly available for the benefit of future researchers. Our computational results indicate that the scaled version of our subset SSD approach outperforms the S&P500. Our approach also outperforms the standard SSD based approach to the problem. Our results show, that for the S&P500 data considered, including sector constraints improves out-of-sample performance, irrespective of the SSD approach adopted. Results are also given for Fama-French data involving 49 industry portfolios and these confirm the effectiveness of our subset SSD approach.