Enhanced index tracking: A relative downside risk approach

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.