A comprehensive review and analysis of different modeling approaches for financial index tracking problem

Abstract

Index tracking, also known as passive investing, has gained significant traction in financial markets due to its cost-effective and efficient approach to replicating the performance of a specific market index. This review paper provides a comprehensive overview of the various modeling approaches and strategies developed for index tracking, highlighting the strengths and limitations of each approach. We categorize the index tracking models into three broad frameworks: optimization-based models, statistical-based models and machine learning based data-driven approach. A comprehensive empirical study conducted on the S\&P 500 dataset demonstrates that the tracking error volatility model under the optimization-based framework delivers the most precise index tracking, the convex co-integration model, under the statistical-based framework achieves the strongest return-risk balance, and the deep neural network with fixed noise model within the data-driven framework provides a competitive performance with notably low turnover and high computational efficiency. By combining a critical review of the existing literature with comparative empirical analysis, this paper aims to provide insights into the evolving landscape of index tracking and its practical implications for investors and fund managers.