Risk parity portfolio optimization under a Markov regime-switching framework

Abstract

We formulate and solve a risk parity optimization problem under a Markov regime-switching framework to improve parameter estimation and to systematically mitigate the sensitivity of optimal portfolios to estimation error. A regime-switching factor model of returns is introduced to account for the abrupt changes in the behaviour of economic time series associated with financial cycles. This model incorporates market dynamics in an effort to improve parameter estimation. We proceed to use this model for risk parity optimization and also consider the construction of a robust version of the risk parity optimization by introducing uncertainty structures to the estimated market parameters. We test our model by constructing a regime-switching risk parity portfolio based on the Fama–French three-factor model. The out-of-sample computational results show that a regime-switching risk parity portfolio can consistently outperform its nominal counterpart, maintaining a similar ex post level of risk while delivering higher-than-nominal returns over a long-term investment horizon. Moreover, we present a dynamic portfolio rebalancing policy that further magnifies the benefits of a regime-switching portfolio.