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Enhanced index tracking: A relative downside risk approach

Author

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  • Luo, Ronghua
  • Huang, Zeyu
  • Liu, Yangyi

Abstract

We introduce the Relative Downside Tracking Error (RDTE) model, a dynamic enhanced indexing method that adapts to the time-varying and mean-reverting nature of market volatility. The RDTE model dynamically adjusts the weights assigned to downside deviations based on market volatility, allowing for greater flexibility during high-volatility periods. This flexibility helps the model reduce the emphasis on short-term fluctuations, focusing instead on minimizing overall downside risk. By doing so, the model effectively controls portfolio distortion, leading to more stable long-term performance. Empirical analyses of U.S. and Chinese stock markets demonstrate that the RDTE model consistently outperforms traditional models, delivering higher returns, lower downside risk, and better risk-adjusted performance. This outperformance is driven by the RDTE model’s effective downside risk management during volatile periods, as confirmed by its superior long-term performance in both markets.

Suggested Citation

  • Luo, Ronghua & Huang, Zeyu & Liu, Yangyi, 2025. "Enhanced index tracking: A relative downside risk approach," The North American Journal of Economics and Finance, Elsevier, vol. 80(C).
    • Handle: RePEc:eee:ecofin:v:80:y:2025:i:c:s106294082500141x
    DOI: 10.1016/j.najef.2025.102501
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    Keywords

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    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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