Clustering of financial time series with application to index and enhanced index tracking portfolio

A stochastic-optimization technique based on time series cluster analysis is described for index tracking and enhanced index tracking problems. Our methodology solves the problem in two steps, i.e., by first selecting a subset of stocks and then setting the weight of each stock as a result of an optimization process (asset allocation). Present formulation takes into account constraints on the number of stocks and on the fraction of capital invested in each of them, whilst not including transaction costs. Computational results based on clustering selection are compared to those of random techniques and show the importance of clustering in noise reduction and robust forecasting applications, in particular for enhanced index tracking. (c) 2005 Elsevier B.V. All rights reserved.