Index Fund Optimization Using a Genetic Algorithm and a Heuristic Local Search

Abstract

It is well known that index funds are popular passively managed portfolios and have been used very extensively for the hedge trading. Index funds consist of a certain number of stocks of listed companies on a stock market such that the fund's return rates follow a similar path to the changing rates of the market indices. However it is hard to make a perfect index fund consisting of all companies included in the given market index. Thus, the index fund optimization can be viewed as a combinatorial optimization for portfolio managements. In this paper, we propose an optimization method that consists of a genetic algorithm and a heuristic local search algorithm to make strong linear association between the fund's return rates and the changing rates of market index. We apply the method to the Tokyo Stock Exchange and make index funds whose return rates follow a similar path to the changing rates of Tokyo Stock Price Index (TOPIX). The results show that our proposal method makes the index funds with strong linear association to the market index by small computing time.