Abstract
It is now an accepted fact that the majority of financial markets worldwide are neither normal nor constant, and South Africa is no exception. One idea that can be used to understand such markets and has been gaining popularity recently is that of regimes and regime-switching models. In this research, we consider whether regimes can add value to the asset allocation process. Four methods for regime identification – economic cycle variables, fundamental valuation metrics, technical market indicators and statistical regime-switching models – are discussed and tested on two asset universes – long-only South African equity factor returns and representative balanced portfolio asset class returns. We find several promising regime indicators and use these to create two regime-based tactical allocation frameworks. Out-of-sample testing on both the equity factor and balanced asset class data shows very promising results, with both regime-based tactical strategies outperforming their respective static benchmarks on an absolute return and risk-adjusted return basis.
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