Cross-region and cross-sector asset allocation with regimes

Authors


  • The authors gratefully acknowledge the research funding and support provided by UniSuper. We are indebted to an anonymous referee and seminar participants at UniSuper, Quantitative Group and Monash University Symposium, Australasian Finance and Banking Conference and Hong Kong Polytechnic University, and the comments of Adrian Pagan, John Pearce, Adam Merrington, Dennis Sams, David Tan, Sirimon Treepongkaruna, and Cameron Truong, which improved the paper substantially. All remaining errors are authors' responsibility.

Abstract

Cross-region and cross-sector asset allocation decisions are one of the most fundamental issues in international equity portfolio management. Equity returns exhibit higher volatilities and correlations, and lower expected returns, in bear markets compared to bull markets. However, static mean–variance analysis fails to capture this salient feature of equity returns. We accommodate the nonlinearity of returns using a regime switching model across both regions and sectors. The regime-dependent asset allocation potentially adds value to the traditional static mean–variance allocation. In addition, optimal allocation across sectors provide greater benefits compared to international diversification, which is characterized by higher returns, lower risks, lower correlations with the world market and a higher Sharpe ratio.

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