A novel dynamic asset allocation system using Feature Saliency Hidden Markov models for smart beta investing

Research output: Contribution to journalArticlepeer-review

Abstract

The financial crisis of 2008 generated interest in more transparent, rules-based strategies for portfolio construction, with smart beta strategies emerging as a trend among institutional investors. Whilst they perform well in the long run, these strategies often suffer from severe short-term drawdown (peak-to-trough decline) with fluctuating performance across cycles. To manage short term risk (cyclicality and underperformance), we build a dynamic asset allocation system using Hidden Markov Models (HMMs). We use a variety of portfolio construction techniques to test our smart beta strategies and the resulting portfolios show an improvement in risk-adjusted returns, especially on more return-oriented portfolios (up to 50% of return in excess of market adjusted by relative risk annually). In addition, we propose a novel smart beta allocation system based on the Feature Saliency HMM (FSHMM) algorithm that performs feature selection simultaneously with the training of the HMM, to improve regime identification. We evaluate our systematic trading system with real life assets using MSCI indices; further, the results (up to 60% of return in excess of market adjusted by relative risk annually) show model performance improvement with respect to portfolios built using full feature HMMs.

Bibliographical metadata

Original languageEnglish
Pages (from-to)113720
JournalExpert Systems with Applications
Volume163
Early online date15 Jul 2020
DOIs
Publication statusE-pub ahead of print - 15 Jul 2020