The Effect of Market Regimes on Style Allocation

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, e.g., 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 overall the forecasting ability for the regime-switching model seems to be weak compared to the iid model.

http://www.springerlink.com/content/eh50266460045432/