The Effect of Market Regimes on Style Allocation

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.

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Correspondence to Manuel Ammann.

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Ammann, M., Verhofen, M. The Effect of Market Regimes on Style Allocation. Fin Mkts Portfolio Mgmt 20, 309–337 (2006). https://doi.org/10.1007/s11408-006-0018-2

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Keywords

  • Regime switching
  • Style investing
  • Markov Chain Monte Carlo
  • Tactical asset allocation

JEL Classification Numbers

  • G11
  • G12
  • G14