Building optimal regime-switching portfolios

Vito Ciciretti and Andrea Bucci

The North American Journal of Economics and Finance, 2023, vol. 64, issue C

Abstract: This paper introduces a novel portfolio optimization method, the Clustered Minimum Spanning Tree Nested Optimization, capable of overcoming the limitations of classical asset allocation, such as instability and over-concentration of portfolio weights, and providing a defensive mechanism against the enhanced systematic risk during high-volatility periods. To do so, we follow a graph theory and clustering-based multi-step approach that accounts also for volatility regime switches. In a bootstrapping setup, we show that our approach produces well-diversified and stable portfolios outperforming the competing methods in terms of risk-adjusted performance while curtailing tail risk by achieving lower portfolio kurtosis.

Keywords: Portfolio optimization; Portfolio construction; Regime-switching; Eigenvector centrality; Graph theory; Hierarchical clustering (search for similar items in EconPapers)
JEL-codes: C38 C58 C61 G10 G11 (search for similar items in EconPapers)
Date: 2023
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Persistent link: https://EconPapers.repec.org/RePEc:eee:ecofin:v:64:y:2023:i:c:s1062940822001723

DOI: 10.1016/j.najef.2022.101837

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