Cross-Region, Cross-Sector Asset Allocation with Regimes
52 Pages Posted: 9 Aug 2010 Last revised: 27 Jan 2013
Date Written: June 29, 2010
Cross-region and cross-sector asset allocation decisions are one of the most fundamental issues in international equity portfolio management. Equity returns exhibit higher volatilities and correlations, and lower expected returns, in bear markets compared to bull markets. However, static mean-variance analysis fails to capture this salient feature of equity returns. Using a regime switching model across both regions and sectors, the regime-dependent asset allocation substantially outperforms the static mean-variance allocation. This outperformance is robust to various asset allocation constraints. In addition, optimal allocation across sectors provide greater benefits compared to international diversification, which is characterized by higher returns, lower risks, lower correlations with the world market and a higher Sharpe ratio.
Keywords: strategic asset allocation, Dynamic asset allocation, International diversification, sector rotation, regime switching, Markov switching
JEL Classification: G11, E30, C22, C13
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