An examination of HMM-based investment strategies for asset allocation

Abstract

We develop and analyse investment strategies relying on hidden Markov model approaches. In particular, we use filtering techniques to aid an investor in his decision to allocate all of his investment fund to either growth or value stocks at a given time. As this allows the investor to switch between growth and value stocks, we call this first strategy a switching investment strategy. This switching strategy is compared with the strategies of purely investing in growth or value stocks by tracking the quarterly terminal wealth of a hypothetical portfolio for each strategy. Using the data sets on Russell 3000 growth index and Russell 3000 value index compiled by Russell Investment Services for the period 1995–2008, we find that the overall risk-adjusted performance of the switching strategy is better than that of solely investing in either one of the indices. We also consider a second strategy referred to as a mixed investment strategy which enables the investor to allocate an optimal proportion of his investment between growth and value stocks given a level of risk aversion. Numerical demonstrations are provided using the same data sets on Russell 3000 growth and value indices. The switching investment strategy yields the best or second best Sharpe ratio as compared with those obtained from the pure index strategies and mixed strategy in 14 intervals. The performance of the mixed investment strategy under the HMM setting is also compared with that of the classical mean–variance approach. To make the comparison valid, we choose the same level of risk aversion for each set-up. Our findings show that the mixed investment strategy within the HMM framework gives higher Sharpe ratios in 5 intervals of the time series than that given by the standard mean–variance approach. The calculated weights through time from the strategy incorporating the HMM set-up are more stable. A simulation analysis further shows a higher performance stability of the HMM strategies compared with the pure strategies and the mean–variance strategy. Copyright © 2009 John Wiley & Sons, Ltd.