Dynamic Asset Allocation Under Regime Switching: An In-Sample And Out-Of-Sample Study Under The Copula-Opinion Pooling Framework
Creators: name: Bartolucci, Andrea
Publisher: name: Zenodo
Year: 2016
Subjects: portfolio management
asset allocation
markov regime switching model
copula opinion-pooling approach

description: My work consists of a comparative study of the performances of the multivariate regime switching model against the single regime model in terms of portfolio returns in the context of dynamic asset allocation. The study was conducted through the practical application, both in-sample and out of-sample, of the two models under various portfolio optimization approaches.

In the first part of the asset allocation exercise I constructed for any asset pricing model, both in-sample and out-of-sample, two dynamic recursive efficient portfolios that maximize the Sharpe among portfolios on the efficient frontier (one with opened budget constraint that permits between 0% and 100% in the riskless asset, one whose weights must sum to 1); in addition short selling, thus negative asset class weights, is not allowed. The other three dynamic recursive portfolios that I constructed have been chosen as those that maximize the investor utility function with three different risk aversion coefficient subject to non-negative weights and opened upper budget constraint.

The second part of the asset allocation exercise focuses only on the out-of-sample period. Here the Copula-Opinion Pooling approach is applied to implement in the asset pricing model views on the asset returns produced by both the single regime model and the regime switching model. The purpose of this section is to investigate and make a comparison of the behavior of the regime switching model and the single state model in the COP framework in terms of both expected and realized portfolio returns and Sharpe ratio in the context of mean-variance and conditional value-atrisk (CVaR) portfolio optimization. Therefore, in addition to the five recursive optimal portfolios chosen with the same portfolio selection process as in the first part, here using conditional value-at-risk as the risk exposure constraint, I derived the dynamic optimal weights of other five different portfolios equally distributed, in terms of CVaR, along the time dependent efficient frontier for different values of the confidence in the views.

The overperformance can be achieved by the more efficient and desirable risk-reward combinations on the state-dependent frontier that can be obtained only by systematically altering portfolio allocations in response to changes in the investment opportunities as the economy switches back and forth among different states. An investor who ignores regimes sits on the unconditional frontier, thus an investor can do better by holding a higher Sharpe ratio portfolio when the low volatility regime prevails. Conversely, when the bad regime occurs, the investor who ignores regimes holds too high a risky asset weight. She would have been better off shifting into the risk-free asset when the bear regime hits. As a consequence, the presence of two regimes and two frontiers means that the regime switching investment opportunity set dominates the investment opportunity set offered by one frontier.