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How do Regimes Affect Asset Allocation?

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  • Andrew Ang
  • Geert Bekaert

Abstract

International equity returns are characterized by episodes of high volatility and unusually high correlations coinciding with bear markets. We develop models of asset returns that match these patterns and use them in asset allocation. First, the presence of regimes with different correlations and expected returns is difficult to exploit within a framework focused on global equities. Nevertheless, for all-equity portfolios, a regime-switching strategy dominates static strategies out-of-sample. Second, substantial value is added when an investor chooses between cash, bonds and equity investments. When a persistent bear market hits, the investor switches primarily to cash. There are large market timing benefits because the bear market regimes tend to coincide with periods of relatively high interest rates.

Suggested Citation

  • Andrew Ang & Geert Bekaert, 2003. "How do Regimes Affect Asset Allocation?," NBER Working Papers 10080, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:10080
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    References listed on IDEAS

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    1. Andrew Ang & Geert Bekaert, 2002. "International Asset Allocation With Regime Shifts," Review of Financial Studies, Society for Financial Studies, vol. 15(4), pages 1137-1187.
    2. Ang, Andrew & Bekaert, Geert, 2002. "Short rate nonlinearities and regime switches," Journal of Economic Dynamics and Control, Elsevier, vol. 26(7-8), pages 1243-1274, July.
    3. Gray, Stephen F., 1996. "Modeling the conditional distribution of interest rates as a regime-switching process," Journal of Financial Economics, Elsevier, vol. 42(1), pages 27-62, September.
    4. Fama, Eugene F. & Schwert, G. William, 1977. "Asset returns and inflation," Journal of Financial Economics, Elsevier, vol. 5(2), pages 115-146, November.
    5. Ang, Andrew & Bekaert, Geert, 2002. "Regime Switches in Interest Rates," Journal of Business & Economic Statistics, American Statistical Association, vol. 20(2), pages 163-182, April.
    6. Bekaert, Geert & Hodrick, Robert J. & Marshall, David A., 2001. "Peso problem explanations for term structure anomalies," Journal of Monetary Economics, Elsevier, vol. 48(2), pages 241-270, October.
    7. Hamilton, James D, 1989. "A New Approach to the Economic Analysis of Nonstationary Time Series and the Business Cycle," Econometrica, Econometric Society, vol. 57(2), pages 357-384, March.
    8. Green, Richard C & Hollifield, Burton, 1992. " When Will Mean-Variance Efficient Portfolios Be Well Diversified?," Journal of Finance, American Finance Association, vol. 47(5), pages 1785-1809, December.
    9. Massimo Guidolin & Allan Timmerman, 2005. "Optimal portfolio choice under regime switching, skew and kurtosis preferences," Working Papers 2005-006, Federal Reserve Bank of St. Louis.
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    Citations

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    Cited by:

    1. Andrew Ang & Allan Timmermann, 2012. "Regime Changes and Financial Markets," Annual Review of Financial Economics, Annual Reviews, vol. 4(1), pages 313-337, October.
    2. Nicholas Chan & Mila Getmansky & Shane M. Haas & Andrew W. Lo, 2007. "Systemic Risk and Hedge Funds," NBER Chapters,in: The Risks of Financial Institutions, pages 235-338 National Bureau of Economic Research, Inc.
    3. Garcia, René & Tsafack, Georges, 2011. "Dependence structure and extreme comovements in international equity and bond markets," Journal of Banking & Finance, Elsevier, vol. 35(8), pages 1954-1970, August.
    4. Guidolin, Massimo & Hyde, Stuart, 2012. "Can VAR models capture regime shifts in asset returns? A long-horizon strategic asset allocation perspective," Journal of Banking & Finance, Elsevier, vol. 36(3), pages 695-716.
    5. Mili, Mehdi, 2012. "Fixed-income portfolio management in crisis period: Expected tail loss (ETL) approach," Economics Discussion Papers 2012-33, Kiel Institute for the World Economy (IfW).
    6. Chollete, Loran & Jaffee, Dwight, 2009. "Economic Implications of Extreme and Rare Events," UiS Working Papers in Economics and Finance 2009/32, University of Stavanger.
    7. Manuel Ammann & Michael Verhofen, 2006. "The Effect of Market Regimes on Style Allocation," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 20(3), pages 309-337, September.
    8. Stefania D'Amico, 2004. "Density Estimation and Combination under Model Ambiguity," Computing in Economics and Finance 2004 273, Society for Computational Economics.
    9. Patrick Roger & Marie-Hélène Broihanne & Maxime Merli, 2012. "In search of positive skewness: the case of individual investors," Working Papers of LaRGE Research Center 2012-04, Laboratoire de Recherche en Gestion et Economie (LaRGE), Université de Strasbourg.
    10. Monica Billio & Mila Getmansky & Loriana Pelizzon, 2006. "Phase-Locking and Switching Volatility in Hedge Funds," Working Papers 2006_54, Department of Economics, University of Venice "Ca' Foscari".
    11. Massimo Guidolin & Giovanna Nicodano, 2010. "Ex Post Portfolio Performance with Predictable Skewness and Kurtosis," Carlo Alberto Notebooks 191, Collegio Carlo Alberto.
    12. Stefania D'Amico, 2005. "Density selection and combination under model ambiguity: an application to stock returns," Finance and Economics Discussion Series 2005-09, Board of Governors of the Federal Reserve System (U.S.).

    More about this item

    JEL classification:

    • F30 - International Economics - - International Finance - - - General
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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