Incorporating Market Regimes into Large-Scale Stock Portfolios: A Hidden Markov Model Approach

Francisco Ibanez and Giovanni Urga

MPRA Paper from University Library of Munich, Germany

Abstract: We propose a portfolio construction method that accounts for the regime-dependent behavior of stocks, thereby impacting their expected returns. Using a hidden Markov model (HMM) and a regime-weighted least-squares approach, we estimate forward-looking regime-conditional factors. These factors help build large-scale stock portfolios for systematic investment management, considering financial market regimes. In historical simulations, our framework achieves superior risk-adjusted performance compared to passive portfolios in both relative and absolute management settings.

Keywords: Regime modeling; portfolio construction; hidden Markov model; least-squares; factor models (search for similar items in EconPapers)
JEL-codes: C1 C2 C32 C4 C61 C63 E32 G11 (search for similar items in EconPapers)
Date: 2024-07
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Persistent link: https://EconPapers.repec.org/RePEc:pra:mprapa:121552

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