Portfolio Management under Multiple Regimes: Strategies that Outperform the Market

Abstract

Context: regime switching models in asset allocation under the stochastic differential utility function were not included in the literature until Campani, Garcia and Lewin (2020) model. This function is at the knowledge edge because, more realistically than the others, it separates the investor main risk parameters. Such configuration, however, becomes so complex that it does not admit an exact solution in the literature and Monte Carlo simulation is not efficient to solve the problem in real time. The model solves that issue with an approximate solution, which is fairly accurate for allocation, and our article offers the first application outside the North American scenario. Objective: evaluate portfolio strategies based on the model on screen and compare their performances with the returns of the main benchmarks of the market. Methods: we propose strategies with and without short selling under four unobservable economic regimes based on the asset returns from: cash (CDI), fixed income (IMA-G), domestic stocks (IBrX-100) and international stocks (S&P 500) in Brazilian Reais. With these parameters, we estimate the regimes probabilities and define each asset weights in the portfolios (multi-regime strategies). Then, we compare these portfolios performances with market indexes and the myopic models (single regime strategies), calculating the statistical significance of the results using Wilcox test. Results: with this research, we pioneer identifying for the first time four economic regimes in Brazil for portfolio optimization. The results indicate that (i) the portfolio policy strongly depends on the current economy state; and (ii) the proposed strategies outperform the market in terms of returns and Sharpe ratio. Conclusion: regime switching models are relevant for portfolio management, and strategies based on these models might imply in solutions that benefit investment managers.

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