Markov-switching asset allocation: Do profitable strategies exist?

• DOI: 10.1057/jam.2010.27
• Publication Date: 2011-03-03T09:00:04Z
• Authors: Jan Bulla; Sascha Mergner; Ingo Bulla; André Sesboüé; Christophe Chesneau
• Keywords: Hidden Markov model; Markov-switching model; asset allocation; timing; volatility regimes; daily returns; jel:G15; 8. Economic growth; jel:C13; jel:E44; jel:C22; 0101 mathematics; 01 natural sciences; jel:G11; jel:C15

This article 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 United States, Japan and Germany over the past 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 per cent. In addition, annualized excess returns attain 18.5 to 201.6 basis points.