Journal of Investment Strategies

Risk.net

A combined regime-switching and Black–Litterman model for optimal asset allocation

Edwin O. Fischer and Michael Murg

ABSTRACT

Traditionally, portfolios are optimized with a single-regime Markowitz model, using volatility as the risk measure and historical return as the expected return. This paper shows what effects a regime-switching framework, alternative risk measures (modifiedvalue-at-risk and conditional value-at-risk) and return measures (capital asset pricing model estimates and Black-Litterman estimates) can have on asset allocation as well as the absolute and relative performance of portfolios. We show that the combination of alternative risk and return measures within the regime-switching framework gives significantly better results in terms of performance and a modified Sharpe ratio. The use of alternative risk and return measures also mitigates the issue that asset returns are not often normally distributed or serially correlated. To eliminate the empirical shortcomings of asset returns, an unsmoothing algorithm in combination with the Cornish-Fisher expansion is used.


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