Ibanez, Francisco and Urga, Giovanni (2024): Incorporating Market Regimes into Large-Scale Stock Portfolios: A Hidden Markov Model Approach.
![]() |
PDF
MPRA_paper_121552.pdf Download (992kB) |
Abstract
We propose a portfolio construction method that accounts for the regime-dependent behavior of stocks, thereby impacting their expected returns. Using a hidden Markov model (HMM) and a regime-weighted least-squares approach, we estimate forward-looking regime-conditional factors. These factors help build large-scale stock portfolios for systematic investment management, considering financial market regimes. In historical simulations, our framework achieves superior risk-adjusted performance compared to passive portfolios in both relative and absolute management settings.
Item Type: | MPRA Paper |
---|---|
Original Title: | Incorporating Market Regimes into Large-Scale Stock Portfolios: A Hidden Markov Model Approach |
Language: | English |
Keywords: | Regime modeling, portfolio construction, hidden Markov model, least-squares, factor models |
Subjects: | C - Mathematical and Quantitative Methods > C1 - Econometric and Statistical Methods and Methodology: General C - Mathematical and Quantitative Methods > C2 - Single Equation Models ; Single Variables C - Mathematical and Quantitative Methods > C3 - Multiple or Simultaneous Equation Models ; Multiple Variables > C32 - Time-Series Models ; Dynamic Quantile Regressions ; Dynamic Treatment Effect Models ; Diffusion Processes ; State Space Models C - Mathematical and Quantitative Methods > C4 - Econometric and Statistical Methods: Special Topics C - Mathematical and Quantitative Methods > C6 - Mathematical Methods ; Programming Models ; Mathematical and Simulation Modeling > C61 - Optimization Techniques ; Programming Models ; Dynamic Analysis C - Mathematical and Quantitative Methods > C6 - Mathematical Methods ; Programming Models ; Mathematical and Simulation Modeling > C63 - Computational Techniques ; Simulation Modeling E - Macroeconomics and Monetary Economics > E3 - Prices, Business Fluctuations, and Cycles > E32 - Business Fluctuations ; Cycles G - Financial Economics > G1 - General Financial Markets > G11 - Portfolio Choice ; Investment Decisions |
Item ID: | 121552 |
Depositing User: | Francisco Ibáñez |
Date Deposited: | 30 Jul 2024 00:46 |
Last Modified: | 30 Jul 2024 00:46 |
References: | Andrew Ang and Geert Bekaert. International Asset Allocation With Regime Shifts. Review of Financial Studies, 15(4):1137–1187, 7 2002a. ISSN 0893-9454. doi: 10.1093/rfs/15.4.1137. Andrew Ang and Geert Bekaert. Regime Switches in Interest Rates. Journal of Business & Economic Statistics, 20(2):163–182, 4 2002b. ISSN 0735-0015. doi: 10.1198/073500102317351930. Andrew Ang and Allan Timmermann. Regime Changes and Financial Markets. An- nual Review of Financial Economics, 4(1):313–337, 10 2012. ISSN 1941-1367. doi: 10.1146/annurev-financial-110311-101808. Lieven Baele, Geert Bekaert, Seonghoon Cho, Koen Inghelbrecht, and Antonio Moreno. Macroeconomic regimes. Journal of Monetary Economics, 70:51–71, 3 2015. ISSN 03043932. doi: 10.1016/j.jmoneco.2014.09.003. Turan G. Bali, Robert F. Engle, and Scott Murray. Empirical Asset Pricing: The Cross Section of Stock Returns. Wiley, Hoboken, NJ, 2016. Ravi Bansal and Hao Zhou. Term Structure of Interest Rates with Regime Shifts. The Jour- nal of Finance, 57(5):1997–2043, 10 2002. ISSN 0022-1082. doi: 10.1111/0022-1082.00487. Nizar Bouguila, Wentao Fan, and Manar Amayri. Hidden Markov Models and Applica- tions. Springer International Publishing, Cham, 2022. ISBN 978-3-030-99141-8. doi: 10.1007/978-3-030-99142-5. Jan Bulla, Sascha Mergner, Ingo Bulla, Andr ́e Sesbo ̈u ́e, and Christophe Chesneau. Markov- switching asset allocation: Do profitable strategies exist? Journal of Asset Management, 12(5):310–321, 11 2011. ISSN 1470-8272. doi: 10.1057/jam.2010.27. Leunglung Chan. An Exact Formula for Pricing American Exchange Options with Regime Switching. pages 211–226. 2014. doi: 10.1007/978-1-4899-7442-6 9. Qiang Dai, Kenneth J. Singleton, and Wei Yang. Regime Shifts in a Dynamic Term Structure Model of U.S. Treasury Bond Yields. Review of Financial Studies, 20(5):1669–1706, 9 2007. ISSN 0893-9454. doi: 10.1093/rfs/hhm021. Eugene F. Fama and Kenneth R. French. Common risk factors in the returns on stocks and bonds. Journal of Financial Economics, 33(1):3–56, 2 1993. ISSN 0304405X. doi: 10.1016/0304-405X(93)90023-5. Eugene F. Fama and Kenneth R. French. A five-factor asset pricing model. Journal of Finan- cial Economics, 116(1):1–22, 4 2015. ISSN 0304405X. doi: 10.1016/j.jfineco.2014.10.010. Andrew Filardo. Choosing information variables for transition probabilities in a time-varying transition probability Markov switching model. 1998. Massimo Guidolin and Allan Timmermann. Asset allocation under multivariate regimeswitching. Journal of Economic Dynamics and Control, 31(11):3503–3544, 11 2007. ISSN 01651889. doi: 10.1016/j.jedc.2006.12.004. James Hamilton. What’s Real About the Business Cycle? Technical report, National Bureau of Economic Research, Cambridge, MA, 2 2005. James D. Hamilton. Regime switching models. In Macroeconometrics and Time Series Analysis, pages 202–209. Palgrave Macmillan UK, London, 2010. doi: 10.1057/9780230280830 23. Joop Huij and Jeroen Derwall. Global equity fund performance, portfolio concentration, and the fundamental law of active management. Journal of Banking & Finance, 35(1): 155–165, 1 2011. ISSN 03784266. doi: 10.1016/j.jbankfin.2010.07.032. Shih-Tang Hwu, Chang-Jin Kim, and Jeremy Piger. AN ¡i¿N¡/i¿ -STATE ENDOGENOUS MARKOV-SWITCHING MODEL WITH APPLICATIONS IN MACROECONOMICS AND FINANCE. Macroeconomic Dynamics, 25(8):1937–1965, 12 2021. ISSN 1365-1005. doi: 10.1017/S1365100519000920. Bruce I. Jacobs, Kenneth N. Levy, and Harry M. Markowitz. Portfolio Optimization with Factors, Scenarios, and Realistic Short Positions. Operations Research, 53(4):586–599, 8 2005. ISSN 0030-364X. doi: 10.1287/opre.1050.0212. Chris Kelliher, Avishek Hazrachoudhury, and Bill Irving. A Novel Approach to Risk Par- ity: Diversification across Risk Factors and Market Regimes. The Journal of Portfolio Management, 48(4):73–90, 2 2022. ISSN 0095-4918. doi: 10.3905/jpm.2022.1.327. Young Min Kim and Kyu Ho Kang. Bayesian Inference of Multivariate Regression Models with Endogenous Markov Regime-Switching Parameters. Journal of Financial Economet- rics, 20(3):391–436, 6 2022. ISSN 1479-8409. doi: 10.1093/jjfinec/nbaa021. Mark Kritzman, S ́ebastien Page, and David Turkington. Regime Shifts: Implications for Dynamic Strategies (corrected). Financial Analysts Journal, 68(3):22–39, 5 2012. ISSN 0015-198X. doi: 10.2469/faj.v68.n3.3. Rogemar S. Mamon and Robert J. Elliott, editors. Hidden Markov Models in Finance, volume 209. Springer US, Boston, MA, 2014. ISBN 978-1-4899-7441-9. doi: 10.1007/978- 1-4899-7442-6. Peter Nystrup, Bo William Hansen, Henrik Madsen, and Erik Lindstr ̈om. Regime-Based Versus Static Asset Allocation: Letting the Data Speak. The Journal of Portfolio Man- agement, 42(1):103–109, 10 2015. ISSN 0095-4918. doi: 10.3905/jpm.2015.42.1.103. Peter Nystrup, Stephen Boyd, Erik Lindstr ̈om, and Henrik Madsen. Multi-period portfolio selection with drawdown control. Annals of Operations Research, 282(1-2):245–271, 11 2019. ISSN 0254-5330. doi: 10.1007/s10479-018-2947-3. Michael T. Owyang and Garey Ramey. Regime switching and monetary policy measure- ment. Journal of Monetary Economics, 51(8):1577–1597, 11 2004. ISSN 03043932. doi: 10.1016/j.jmoneco.2004.01.004. Andre F. Perold. Large-Scale Portfolio Optimization. Management Science, 30(10):1143– 1160, 10 1984. ISSN 0025-1909. doi: 10.1287/mnsc.30.10.1143. Abdullah Z. Sheikh and Jianxiong Sun. Regime Change: Implications of Macroeconomic Shifts on Asset Class and Portfolio Performance. The Journal of Investing, 21(3):36–54, 8 2012. ISSN 1068-0896. doi: 10.3905/joi.2012.21.3.036. Tyler Shumway. The Delisting Bias in CRSP Data. The Journal of Finance, 52(1):327–340, 3 1997. Christopher A Sims and Tao Zha. Were There Regime Switches in U.S. Monetary Policy? American Economic Review, 96(1):54–81, 2 2006. ISSN 0002-8282. doi: 10.1257/000282806776157678. Tak Kuen Siu. A Hidden Markov-Modulated Jump Diffusion Model for European Option Pricing. pages 185–209. 2014. doi: 10.1007/978-1-4899-7442-6 8. Wei Yang. Business Cycles, Regime Shifts, and Return Predictability. Journal of Fi- nancial and Quantitative Analysis, 58(7):3058–3084, 11 2023. ISSN 0022-1090. doi: 10.1017/S0022109023000261. |
URI: | https://mpra.ub.uni-muenchen.de/id/eprint/121552 |