Regime Switching Portfolio Optimisation for International Indices: Case of Indian Subcontinent

Abstract

This paper expands the literature on emerging markets by evaluating gains from diversifying into emerging equity markets. The price index data from three stock exchanges, Pakistan Stock Exchange (KSE-100), Bombay Stock Exchange (BSE-100) and Dhaka Stock Exchange (DSEX) and MSCI AC World EM Asia (MSCI) as benchmark is used. The theme is to continuously rebalance the portfolio from the weights generated by the regime switching (RS CAPM) model and compare them with simple mean-variance portfolio (Non-RS) and market value portfolio (Market value (MV) weighted portfolio). Previously, RS CAPM has been found to be successful, but the dataset used here argues that RS CAPM performs better after the crises of 2009 as compared with other two strategies in out-sample period. MV strategy is the most successful until 2009. The justification is lack of correlation of DSEX with MSCI and minimal correlation between the indices. Only BSE and KSE are correlated with MSCI with BSE being highly correlated with MSCI benchmark index. Bekaert et al. (1998b) argued that standard mean-variance analysis is somewhat problematic with respect to emerging equity markets that is why we needed some other technique say Regime Switching and MV to compare with Non-RS method and this study proves their conclusion as RS CAPM and Non-RS underperformed compared with MV strategy. The markets after that have been more active and have been able to attract more international investors due to benefits of diversification. This also confirms that these markets are less efficient and least correlated with that of international markets and have been least affected during the crises periods as compared to other markets.