The Effect of Market Regimes on Style Allocation

45 Pages Posted: 23 Jan 2009  

Manuel Ammann

University of St. Gallen - School of Finance

Michael Verhofen

University of St. Gallen - Swiss Institute of Banking and Finance; Allianz Global Investors

Multiple version iconThere are 2 versions of this paper

Date Written: January 1, 2009

Abstract

We analyse time-varying risk premia and the implications for portfolio choice. Using Markov Chain Monte 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, G14

Suggested Citation

Ammann, Manuel and Verhofen, Michael, The Effect of Market Regimes on Style Allocation (January 1, 2009). Available at SSRN: https://ssrn.com/abstract=1322278 or http://dx.doi.org/10.2139/ssrn.1322278

Manuel Ammann

University of St. Gallen - School of Finance ( email )

Unterer Graben 21
St.Gallen, CH-9000
Switzerland

Michael Verhofen (Contact Author)

Allianz Global Investors ( email )

Frankfurt
Germany

University of St. Gallen - Swiss Institute of Banking and Finance ( email )

Rosenbergstrasse 52
St. Gallen, CH-9000
Switzerland

HOME PAGE: http://www.verhofen.com

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