Chapter 13 Index Tracking Portfolios
If you have assumed a character beyond your strength, you have both played a part ill, and have fallen in an unbecoming manner: you have gone aground.
— Epictetus, The Enchiridion
“I never met another man I’d rather be. And even if that’s a delusion, it’s a lucky one.”
— Charles Bukowski
Can we outsmart the market? The efficient-market hypothesis states that the price of a security already contains all the publicly available information about the future (Fama, 1970), although another line of thought supports precisely the opposite view in favor of inefficient and irrational markets (Shiller, 1981). In any case, beating the market is routinely promised by investment funds, hedge funds, financial experts, but do they keep up their promises? Empirical analysis of data shows that about 95% of funds do not outperform the market (Malkiel, 1973).
This chapter explores the topic of market or index tracking as an alternative to active investment strategies that attempt to beat the market: from heuristic and discretionary approaches, to more sophisticated optimization formulations, and even the most recent techniques to automatically choose the number of active assets in a statistically controlled way.
This material has been published as: Daniel P. Palomar (2025). Portfolio Optimization: Theory and Application. Cambridge University Press. This version is free to view and download for personal use only; not for re-distribution, re-sale, or use in derivative works. © Daniel P. Palomar 2025.