When should you change the allocation of your factor exposure? This is a critical question and ultimately it is a question of market timing. But how do you effectively market time? This timing can be done through looking for regime switches. If we can identify if we are in a bull or bear regime, we should be able to adjust the allocation across factor allocations. Of course, if we could be perfect timers, we would not think about factor exposures, we would just go long the risky asset in a bull market regime and go short in a bear market. Alternatively, we focus on building a portfolio because we know that we will not be perfect in our timing ability.
In the new paper, "Dynamic Factor Allocation Leveraging Regime-Switching Signals", the authors look at seven long-only indices which include the market portfolio and value, size, momentum, quality, low volatility and growth and employ a Black-Litterman model with regime switching. They show that the dynamic portfolio will do better than an equal-weighted portfolio when the allocation decisions are based on a sparse jump (SJM) model. The SJM uses risk and return measures to identify the regimes. It is a form of cluster analysis to find bull and bear behavior across the set of factors analyzed. This regime model is the novel addition to this paper. A regime model is applied to each factor, so each has identified their own bull and bear period.
If you can identify regimes correctly, you can market time. That should seem obvious, and it is. There are many ways to form regimes, so the key job of the PM is to find the right way to identify these regimes.
Note that different regime modeling techniques will generate different regimes for the same data. The regimes for the size factors are very different.
Whether this can be implemented in world of transaction costs, is questionable, but the key concept of using regimes to help build portfolios is very useful.
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