Volatility Regime and Equity Portfolio Return: Evidence from Europe

This paper examines four European equity portfolios sorted by size, book-to-market (B/M) ratios, operating profitability, investment, and momentum by using Markov switching models with high and low volatility regimes. Our empirical analyses derive the following interesting findings. First, in four European equity portfolios, the smallest and the strongest momentum portfolio yields the highest return. In addition, the second smallest and the highest B/M portfolio, the second smallest and the highest operating profitability portfolio, and the second smallest and the second lowest investment portfolio also yield higher returns than the overall equity market in Europe. Further, our analyses using Markov switching models also reveal that for all the four European equity portfolios, the higher returns are obtained not in high volatility regimes but in low volatility regimes, and this evidence is against the assumption of risk-return trade off advocated in standard finance theory. Finally, our Markov switching analyses also suggest that for all the four European portfolios, staying probabilities in the same regimes are high and switching probabilities between two different regimes are generally low. In particular, staying probabilities in low volatility regimes are rather high, thus, all the four European equity portfolios yield high returns very stably by staying high return regimes.