Can VAR models capture regime shifts in asset returns? A long-horizon strategic asset allocation perspective

Arbeitspapier

We examine whether simple VARs can produce empirical portfolio rules similar to those obtained under a range of multivariate Markov switching models, by studying the effects of expanding both the order of the VAR and the number/selection of predictor variables included. In a typical stock-bond strategic asset allocation problem on US data, we compute the out-of-sample certainty equivalent returns for a wide range of VARs and compare these measures of performance with those typical of non-linear models that account for bull-bear dynamics and characterize the differences in the implied hedging demands for a long-horizon investor with constant relative risk aversion preferences. In a horse race in which models are not considered in their individuality but instead as an overall class, we find that a power utility investor with a constant coefficient of relative risk aversion of 5 and 5-year horizon, would be ready to pay as much as 8.1% in real terms to be allowed to select models from the MS class, while analogous calculation for the whole class of expanding window VAR leads to a disappointing 0.3% per annum. We conclude that most (if not all) VARs cannot produce portfolio rules, hedging demands, or out-of-sample performances that approximate those obtained from equally simple non-linear frameworks.

Object Details

• Language: Englisch

References and Relationships

• Bibliographic citation: Series: Manchester Business School Working Paper ; No. 608

Classification and Topics

• Classification: Wirtschaft ; Portfolio Choice; Investment Decisions ; Forecasting Models; Simulation Methods
• Subject: predictability ; strategic asset allocation ; Markov switching ; vector autoregressive models ; out-of-sample performance

Contributors, Places and Time

• Event: Geistige Schöpfung
• (who): Guidolin, Massimo ; Hyde, Stuart
• Event: Veröffentlichung
• (who): The University of Manchester, Manchester Business School
• (where): Manchester
• (when): 2010

Further information

• Handle: http://hdl.handle.net/10419/50679
• Last update: 10.03.2025, 11:42 AM CET