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

Author

Listed:
  • Ibanez, Francisco
  • Urga, Giovanni

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.

Suggested Citation

  • Ibanez, Francisco & Urga, Giovanni, 2024. "Incorporating Market Regimes into Large-Scale Stock Portfolios: A Hidden Markov Model Approach," MPRA Paper 121552, University Library of Munich, Germany.
    • Handle: RePEc:pra:mprapa:121552
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    File URL: https://mpra.ub.uni-muenchen.de/121552/1/MPRA_paper_121552.pdf
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    More about this item

    Keywords

    Regime modeling; portfolio construction; hidden Markov model; least-squares; factor models;
    All these keywords.

    JEL classification:

    • C1 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General
    • C2 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables
    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • C4 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: Special Topics
    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • C63 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computational Techniques
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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