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Mean-variance optimization with inferred regimes

Author

Listed:
  • Leonard MacLean

    (Dalhousie University)

  • Yonggan Zhao

    (Dalhousie University)

  • Oufan Zhang

    (Dalhousie University)

Abstract

The dynamics of financial time series display a cyclical behavior, and the performance of portfolio decisions based on the anticipated distribution of asset returns are sensitive to the alignment of the anticipated distribution and subsequently observed returns in cyclical markets. We consider that the financial market is characterized by factors, and we present a regime-switching auto-regressive model for macro-economic factors to reflect financial cycles. We then define a factor model for the distribution of asset returns, with returns depending on regimes through the factors. The dependence is on the regime sequence in successive periods, or the regime transition. The factor model structure is embedded in the asset expected returns and their corresponding covariance matrix. These regime-dependent parameters serve as the inputs to mean-variance optimization, thereby constructing portfolios adapted to the current market environment. A contrast between investment decisions based on the expectation over regimes or the selection of a single most likely (inferred) regime is provided. The improvements in portfolio performance are calibrated with market data on macroeconomic factors and exchange traded funds as investment instruments.

Suggested Citation

  • Leonard MacLean & Yonggan Zhao & Oufan Zhang, 2025. "Mean-variance optimization with inferred regimes," Annals of Operations Research, Springer, vol. 346(1), pages 341-368, March.
    • Handle: RePEc:spr:annopr:v:346:y:2025:i:1:d:10.1007_s10479-024-06267-z
    DOI: 10.1007/s10479-024-06267-z
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    References listed on IDEAS

    as
    1. Stephen A. Ross, 2013. "The Arbitrage Theory of Capital Asset Pricing," World Scientific Book Chapters, in: Leonard C MacLean & William T Ziemba (ed.), HANDBOOK OF THE FUNDAMENTALS OF FINANCIAL DECISION MAKING Part I, chapter 1, pages 11-30, World Scientific Publishing Co. Pte. Ltd..
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    6. Giorgio Costa & Roy H. Kwon, 2019. "Risk parity portfolio optimization under a Markov regime-switching framework," Quantitative Finance, Taylor & Francis Journals, vol. 19(3), pages 453-471, March.
    7. Rosenberg, Barr & Rudd, Andrew, 1982. "Factor-Related and Specific Returns of Common Stocks: Serial Correlation and Market Inefficiency," Journal of Finance, American Finance Association, vol. 37(2), pages 543-554, May.
    8. Carhart, Mark M, 1997. "On Persistence in Mutual Fund Performance," Journal of Finance, American Finance Association, vol. 52(1), pages 57-82, March.
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    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    Mean-variance optimization; Hidden Markov model; Macroeconomic indicators; Regime-switching auto-regressive factors; Regime-switching regression models; ETF investment;
    All these keywords.

    JEL classification:

    • C1 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General
    • C5 - Mathematical and Quantitative Methods - - Econometric Modeling
    • C6 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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