Regime shifts in mean-variance efficient frontiers: Some international evidence

Abstract

This article examines how the presence of regimes in means, variances and correlations of asset returns translates into explicit dynamics of the Markowitz mean-variance frontier (MVF). In particular, the article shows both theoretically and through an application to international equity portfolio diversification that substantial differences exist between bull and bear regime-specific frontiers, both in statistical and in economic terms. Using Morgan Stanley Capital International investable indices for five countries/macro-regions, it is possible to characterize the MVFs and optimal portfolio strategies in bull periods, in bear periods and in periods in which high uncertainty exists on the nature of the current regime. A recursive back-testing exercise shows that between 1998 and 2010, adopting a switching mean-variance strategy may have yielded considerable risk-adjusted pay-offs, which were the largest in correspondence to the 2007–2009 financial crisis.