Investing in Mutual Funds with Regime Switching

Abstract

This paper develops a Bayesian framework for choosing an optimal portfolio of mutual funds in the presence of regime switching in stock market returns. Specifically, I adopt a Bayesian methodology that allows for regime uncertainty to be incorporated in the investment decision of the investor who wishes to select a portfolio of mutual funds with the highest ex ante Sharpe ratio. I find that for a range of prior beliefs regarding the pricing error of the CAPM and the 4-factor Carhart model, and fund manager skill, recognizing regime switching in market returns exerts a powerful influence on the fund choices of the investor. In order to gauge the economic significance of regime switching for the fund selection decision I calculate the certainty equivalent loss experienced by the investor if she were to ignore the regime switches in market returns. I find that the economic costs of ignoring regime switching are substantial. For example, an investor with complete prior confidence in the Capital Asset Pricing Model but who rules out the possibility of managerial skill, would experience a utility loss of 90% or 267 basis points per month in certainty equivalent terms, when failing to account for the regimes. Alternatively, consider an investor whose prior beliefs attach a 5% probability to the event that asset returns will deviate from the CAPM's predictions by  4% per year. The cost of ignoring regime switches for such an investor ranges between 81 and 100 basis points per month depending on her prior beliefs in managerial skill.