I am trying to recreate this research: Regime-Switching Factor Investing with Hidden Markov Models, by Matthew Wang, Yi-Hong Lin and Ilya Mikhelson https://www.mdpi.com/1911-8074/13/12/311/htm

My first question is when they present the regime breakdown:

Regime Distribution  Return   Volatility
0          0.4237    0.0398   3.4739
1          0.4463    0.04635  0.9438
2          0.13     -0.066    13.63465

These results look great, but don't they suffer from hindsight bias? They're giving the algorithm all of the data so it can look at future states to calculate probability of a past state. For example, say it correctly identifies Sept 2008 as state2 with low returns and high volatility. But to do this, the algorithm used information from Oct 2008 and onwards when determining Sept 2008 was state2? Or am I misunderstanding how this works?

My second question is when they turn to backtesting:

"Once we have the trained HMM, we need to design a mechanism that serves as the aforementioned confidence interval for judging whether a regime switch has occurred. In using the GaussianHMM API from hmmlearn we operate under the assumption that the observation probability distributions for volatility and daily returns are normally distributed. However, in the mechanism we designed for regime detection, we analyzeg regime observations independently. Thus, as can be observed in Figure 5, we utilize the Kolmogorov-Smirnov test to fit the observations to one of many common distributions including normal, lognormal, pareto, gamma, beta and exponential. With new daily returns and volatility values, we are then able to use the probability density function (PDF) of the fitted distribution to compare the likelihood we are currently in each respective regime in relative terms."

I don't understand how they are using a K-S test to use the output from the HMM model into a probability of the regime switching in the future. Doesn't the HMM transition matrix tell you this? Ie. knowing that we are likely in State 1, there is an X probability of staying in State 1 etc?



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