Markov-switching Asset Allocation: Do Profitable Strategies Exist?

Bulla, Jan and Mergner, Sascha and Bulla, Ingo and Sesboüé, André and Chesneau, Christophe (2010): Markov-switching Asset Allocation: Do Profitable Strategies Exist?

Abstract

This paper proposes a straightforward Markov-switching asset allocation model, which reduces the market exposure to periods of high volatility. The main purpose of the study is to examine the performance of a regime-based asset allocation strategy under realistic assumptions, compared to a buy and hold strategy. An empirical study, utilizing daily return series of major equity indices in the US, Japan, and Germany over the last 40 years, investigates the performance of the model. In an out-of-sample context, the strategy proves profitable after taking transaction costs into account. For the regional markets under consideration, the volatility reduces on average by 41%. Additionally, annualized excess returns attain 18.5 to 201.6 basis points.

• Item Type: MPRA Paper
• Language: English
• Keywords: Hidden Markov model; Markov-switching model; asset allocation; timing; volatility regimes; daily returns
• Subjects: C - Mathematical and Quantitative Methods > C1 - Econometric and Statistical Methods and Methodology: General > C13 - Estimation: General; G - Financial Economics > G1 - General Financial Markets > G11 - Portfolio Choice ; Investment Decisions; G - Financial Economics > G1 - General Financial Markets > G15 - International Financial Markets; C - Mathematical and Quantitative Methods > C2 - Single Equation Models ; Single Variables > C22 - Time-Series Models ; Dynamic Quantile Regressions ; Dynamic Treatment Effect Models ; Diffusion Processes; C - Mathematical and Quantitative Methods > C1 - Econometric and Statistical Methods and Methodology: General > C15 - Statistical Simulation Methods: General; E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E44 - Financial Markets and the Macroeconomy

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