Strategic Asset Allocation and Markov Regime Switch with GARCH Model

During the financial crisis of 2008, the S&P 500 Implied Volatility Index (VIX), known as the “fear gauge”, jumped to 80% of the highest level it has ever reached. Portfolio managers faced tremendous pressures in these environments of such high levels market volatility. Because it is well known that asset allocation dominates portfolio performances, this paper focuses on asset allocation strategies. It develops a strategic asset allocation solution for portfolio management under all conditions and at all levels of market volatility. The approach is to derive a dynamic optimal portfolio that is based on the well-known asset allocation Black–Litterman [1991, 1992] framework. In addition, this paper proposes a methodology that considers the features of volatility regime-switching over time. This new strategic framework allows portfolio managers to derive a systematically optimal portfolio in a timely, accurate fashion