The Effect of Market Regimes on Style Allocation
University of St. Gallen - Swiss Institute of Banking and Finance
Allianz Global Investors; University of St. Gallen - Swiss Institute of Banking and Finance
Financial Markets and Portfolio Management, Vol. 20, No. 3, pp. 309-337, 2006
We analyse time-varying risk premia and the implications for portfolio choice. Using Markov ChainMonte Carlo (MCMC) methods, we estimate a multivariate regime-switching model for the Carhart (1997) four-factor model. We find two clearly separable regimes with different mean returns, volatilities, and correlations. In the High-Variance Regime, only value stocks deliver a good performance, whereas in the Low-Variance Regime, the market portfolio and momentum stocks promise high returns. Regime-switching induces investors to change their portfolio style over time depending on the investment horizon, the risk aversion, and the prevailing regime. Value investing seems to be a rational strategy in the High-Variance Regime, momentum investing in the Low-Variance Regime. An empirical out-of-sample backtest indicates that this switching strategy can be profitable, but the overall forecasting ability for the regime-switching model seems to be weak compared to the iid model.
Keywords: Regime switching, Style investing, Markov Chain Monte Carlo, Tactical asset allocation
JEL Classification: G11, G12, G14Accepted Paper Series
Date posted: September 17, 2006
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