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Journal of Financial Econometrics Advance Access originally published online on December 11, 2007
Journal of Financial Econometrics 2008 6(1):1-48; doi:10.1093/jjfinec/nbm021
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© The Author 2007. Published by Oxford University Press. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org

Size and Value Anomalies under Regime Shifts

Massimo Guidolin
     Federal Reserve Bank of St. Louis and Manchester Business School, MAGF

Allan Timmermann
     University of California, San Diego and CREATES

Address correspondence to Prof. Massimo Guidolin, Manchester Business School, Accounting & Finance Group, MBS Crawford House, Booth Street East, Manchester M13 9PL, United Kingdom, email: Massimo.Guidolin{at}mbs.ac.uk. Tel.: +44-(0)161-306-6406; Fax: +44-(0)161-275-402.

JEL Classification: G12, G11, C32


  Abstract

This paper finds strong evidence of time-variations in the joint distribution of returns on a stock market portfolio and portfolios tracking size- and value effects. Mean returns, volatilities and correlations between these equity portfolios are found to be driven by underlying regimes that introduce short-run market timing opportunities for investors. The magnitude of the premia on the size and value portfolios and their hedging properties are found to vary across regimes. Regimes are shown to have a large impact both on the optimal asset allocation—especially under rebalancing—and on investors' utility. Regimes also have a considerable impact on hedging demands, which are positive when the investor starts from more favorable regimes and negative when starting from bad states. Recursive out-of-sample forecasting experiments show that portfolio strategies based on models that account for regimes dominate single-state benchmarks.

KEYWORDS: hedging demands, optimal portfolio choice, regimes, size and value portfolios

We thank the editor, Rene Garcia, an associate editor and two anonymous referees for many helpful suggestions. Useful comments were provided by Fulvio Ortu (a discussant), Phelim Boyle, Christian Haefke, Hashem Pesaran, Lucio Sarno, and by seminar participants at the European Central Bank/CFS/Deutsch Bundesbank workshop, the European Financial Management Association meetings in Milan (June 2005), the Federal Reserve Bank of Atlanta, Universitat Pompeu Fabra Barcelona, University of Cambridge (CERF), University of Copenhagen, University of Waterloo (Eighth Annual Financial Econometrics Conference), and Warwick Business School. The usual disclaimer applies. Allan Timmermann acknowledges research support from CREATES, funded by the Danish National Research Foundation.

Received July 12, 2007; revised April 16, 2007; accepted September 24, 2007


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