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I'm always wondering whether anyone has utilized regime-switching models successfully in forecasting or trading.

Academia has long discussed this topic in-depth, such as using Regime Switching models for detection of abrupt market dislocation or structural changes. Popular techniques include modeling the underlying process as a Markov Process with certain distributions, and use such model to estimate the transition probability matrix.

The premise of this approach is attractive: if we can apply different approaches based on different market regimes, then the modeling process can better reflect the reality. However, like any other model, the reliability of such model is not convincing.

Personally, I've tried implementing some Regime-switch models proposed by academics and test their explanatory power for detecting market shifts (such as shift of cycles, volatility levels, etc), but the results are always disappointing.

Can any fellow friends here share your opinions? Cheers.

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If my answer did help you it is good practice here to upvote and accept it - thank you :-) – vonjd Jul 1 '14 at 7:42

Windham Capital Management is using hidden markov models for their Risk Regime Strategies.

Mark Kritzman, who is also CEO, has published an article about the general outline of the strategy (with source code so you can replicate the results!):

Regime Shifts: Implications for Dynamic Strategies (corrected August 2012) by M. Kritzman, S. Page, D. Turkington


Regime shifts present significant challenges for investors because they cause performance to depart significantly from the ranges implied by long-term averages of means and covariances. But regime shifts also present opportunities for gain. The authors show how to apply Markov-switching models to forecast regimes in market turbulence, inflation, and economic growth. They found that a dynamic process outperformed static asset allocation in backtests, especially for investors who seek to avoid large losses.

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Is this a sales promotion from Windham, to sell their fund? – emcor Jun 27 '14 at 16:56
@emcor: No, not necessarily. Mark Kritzman is also a lecturer at MIT and has published a lot of other interesting research papers over the years. In general I think the more qualified quants are the less secretive they are about their ideas (because they develop superior new ideas all the time). – vonjd Jun 27 '14 at 17:00
Which returns did the fund make since 2012? – emcor Jun 27 '14 at 17:02
@emcor: I don't have any inside information, only what is publicly available. – vonjd Jun 27 '14 at 17:03

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