Four Factors and Two Regimes – Performance in Up and Down Markets

CXO summaries the paper "The Effect of Market Regimes on Style Allocation", by Manuel Ammann and Michael Verhofen:

  • There are two reasonably distinct overall equity market regimes with different mean returns and volatilities: low-volatility and high-volatility. Market volatility is 2.6 times higher for the latter regime than for the former.
  • The low-volatility regime, occurring about three quarters of the time, relates to high annual returns for the overall equity market (10.2%) and momentum stocks (12.4%), and low annual returns for small capitalization stocks (1.9%) and value stocks (2.6%).
  • The high-volatility regime, occurring about one quarter of the time, relates to low annual returns for the overall equity market (0.4%), momentum stocks (-1.3%) and small capitalization stocks (3.1%) and high annual returns for value stocks (15.2%).
  • An out-of-sample backtest indicates that switching styles according to market regime can be profitable. Specifically, momentum investing during the low-volatility regime and value investing during the high-volatility regime outperforms consistently and to a degree that appears profitable after accounting for transaction costs.

This paper agrees broadly with my findings that capital markets are much more volatile and returns lower when trending down (as measured by a long term simple moving average).  The exception is commodities that can be very volatile to the upside due to supply constraints.



Asset Class Market > 10 month SMA Market < 10 month SMA Difference
US Stocks      
% of time 72.92% 27.08%  
Annualized Return 13.49% 3.04% -77.45%
Annualized Volatility 13.89% 19.23% 38.40%
Foreign Stocks      
% of time 69.91% 27.08%  
Annualized Return 14.57% 1.94% -86.71%
Annualized Volatility 14.86% 21.51% 44.76%
% of time 76.16% 27.08%  
Annualized Return 10.03% 6.29% -37.27%
Annualized Volatility 8.69% 10.15% 16.73%
% of time 66.90% 27.08%  
Annualized Return 16.21% 1.09% -93.31%
Annualized Volatility 20.78% 19.64% -5.50%
Real Estate      
% of time 72.45% 27.08%  
Annualized Return 14.84% -1.43% -109.64%
Annualized Volatility 13.51% 23.76% 75.90%
% of time 71.67% 27.08%  
Annualized Return 13.83% 2.19% -84.20%
Annualized Volatility 14.35% 18.86% 31.43%
US Stocks 1901-2008      
% of time 69.88% 30.12%  
Annualized Return 14.42% 3.03% -78.98%
Annualized Volatility 14.30% 24.18% 69.06%





We analyse time-varying risk premia and the implications for portfolio choice. Using Markov Chain Monte Carlo (MCMC) methods, we estimate a multivariate regime-switching model for the Carhart (1997) four-factor model. We find two clearly separable regimes with different mean returns, volatilities and correlations. In the High-Variance Regime, only value stocks deliver a good performance, whereas in the Low-Variance Regime, the market portfolio and momentum stocks promise high returns. Regime-switching induces investors to change their portfolio style over time depending on the investment horizon, the risk aversion, and the prevailing regime. Value investing seems to be a rational strategy in the High-Variance Regime, momentum investing in the Low-Variance Regime. An empirical out-of-sample backtest indicates that this switching strategy can be profitable, but the overall forecasting ability for the regime-switching model seems to be weak compared to the iid model.