Downside Risk Reduction Using Regime-Switching Signals: A Statistical Jump Model Approach

TL;DR

This paper presents a regime-switching investment strategy using a statistical jump model (JM) to identify market regimes, effectively reducing downside risk and improving risk-adjusted returns across major global equity indices from 1990 to 2023.

Contribution

It introduces a robust jump model for regime detection that outperforms traditional models, optimizing strategy performance through a novel jump penalty selection method.

Findings

JM-guided strategy reduces volatility and maximum drawdown.

Strategy improves Sharpe ratio compared to benchmarks.

Outperforms traditional Markov-switching and buy-and-hold strategies.

Abstract

This article investigates a regime-switching investment strategy aimed at mitigating downside risk by reducing market exposure during anticipated unfavorable market regimes. We highlight the statistical jump model (JM) for market regime identification, a recently developed robust model that distinguishes itself from traditional Markov-switching models by enhancing regime persistence through a jump penalty applied at each state transition. Our JM utilizes a feature set comprising risk and return measures derived solely from the return series, with the optimal jump penalty selected through a time-series cross-validation method that directly optimizes strategy performance. Our empirical analysis evaluates the realistic out-of-sample performance of various strategies on major equity indices from the US, Germany, and Japan from 1990 to 2023, in the presence of transaction costs and trading delays. The results demonstrate the consistent outperformance of the JM-guided strategy in reducing risk metrics such as volatility and maximum drawdown, and enhancing risk-adjusted returns like the Sharpe ratio, when compared to both hidden Markov model-guided strategy and the buy-and-hold strategy. These findings underline the enhanced persistence, practicality, and versatility of strategies utilizing JMs for regime-switching signals.