Dynamic portfolio optimization across hidden market regimes
Nystrup, Peter ; Madsen, Henrik and Lindström, Erik LU
(2018)
In Quantitative Finance
18(1).
p.83-95
- Abstract
- Regime-based asset allocation has been shown to add value over rebalancing to static weights and, in particular, reduce potential drawdowns by reacting to changes in market conditions. The predominant approach in previous studies has been to specify in advance a static decision rule for changing the allocation based on the state of financial markets or the economy. In this article, model predictive control (MPC) is used to dynamically optimize a portfolio based on forecasts of the mean and variance of financial returns from a hidden Markov model with time-varying parameters. There are computational advantages to using MPC when estimates of future returns are updated every time a new observation becomes available, since the optimal control... (More)
- Regime-based asset allocation has been shown to add value over rebalancing to static weights and, in particular, reduce potential drawdowns by reacting to changes in market conditions. The predominant approach in previous studies has been to specify in advance a static decision rule for changing the allocation based on the state of financial markets or the economy. In this article, model predictive control (MPC) is used to dynamically optimize a portfolio based on forecasts of the mean and variance of financial returns from a hidden Markov model with time-varying parameters. There are computational advantages to using MPC when estimates of future returns are updated every time a new observation becomes available, since the optimal control actions are reconsidered anyway. MPC outperforms a static decision rule for changing the allocation and realizes both a higher return and a significantly lower risk than a buy-and-hold investment in various major stock market indices. This is after accounting for transaction costs, with a one-day delay in the implementation of allocation changes, and with zero-interest cash as the only alternative to the stock indices. Imposing a trading penalty that reduces the number of trades is found to increase the robustness of the approach. (Less)
Please use this url to cite or link to this publication:
https://lup.lub.lu.se/record/aee3840b-06ee-4e2d-8b50-65f2c0d66b92
- author
- Nystrup, Peter
; Madsen, Henrik
and Lindström, Erik
LU
- organization
- publishing date
- 2018-01
- type
- Contribution to journal
- publication status
- published
- subject
- keywords
- Multi-period portfolio selection, Mean–variance optimization, Model predictive control, Hidden Markov model, Adaptive estimation, Forecasting
- in
- Quantitative Finance
- volume
- 18
- issue
- 1
- pages
- 83 - 95
- publisher
- Taylor & Francis
- external identifiers
-
- scopus:85025435532
- ISSN
- 1469-7688
- DOI
- 10.1080/14697688.2017.1342857
- language
- English
- LU publication?
- yes
- id
- aee3840b-06ee-4e2d-8b50-65f2c0d66b92
- date added to LUP
- 2017-10-26 16:07:04
- date last changed
- 2023-09-14 15:11:05
@article{aee3840b-06ee-4e2d-8b50-65f2c0d66b92,
abstract = {{Regime-based asset allocation has been shown to add value over rebalancing to static weights and, in particular, reduce potential drawdowns by reacting to changes in market conditions. The predominant approach in previous studies has been to specify in advance a static decision rule for changing the allocation based on the state of financial markets or the economy. In this article, model predictive control (MPC) is used to dynamically optimize a portfolio based on forecasts of the mean and variance of financial returns from a hidden Markov model with time-varying parameters. There are computational advantages to using MPC when estimates of future returns are updated every time a new observation becomes available, since the optimal control actions are reconsidered anyway. MPC outperforms a static decision rule for changing the allocation and realizes both a higher return and a significantly lower risk than a buy-and-hold investment in various major stock market indices. This is after accounting for transaction costs, with a one-day delay in the implementation of allocation changes, and with zero-interest cash as the only alternative to the stock indices. Imposing a trading penalty that reduces the number of trades is found to increase the robustness of the approach.}},
author = {{Nystrup, Peter and Madsen, Henrik and Lindström, Erik}},
issn = {{1469-7688}},
keywords = {{Multi-period portfolio selection; Mean–variance optimization; Model predictive control; Hidden Markov model; Adaptive estimation; Forecasting}},
language = {{eng}},
number = {{1}},
pages = {{83--95}},
publisher = {{Taylor & Francis}},
series = {{Quantitative Finance}},
title = {{Dynamic portfolio optimization across hidden market regimes}},
url = {{http://dx.doi.org/10.1080/14697688.2017.1342857}},
doi = {{10.1080/14697688.2017.1342857}},
volume = {{18}},
year = {{2018}},
}