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									               Asset Allocation under Alternative Economic Regimes

                               Corresponding author

                                      J. Sa-Aadu
                               Department of Finance
                         Henry B. Tippie College of Business
                        108 Pappajohn Business Building, S272
                                 University of Iowa,
                                    Iowa City, IA
                            Phone number: (319) 335-0930
                             Fax number: (319) 335-3690

                                 James D. Shilling
                   Department of Real Estate and Urban Economics
                              University of Wisconsin
                                Madison, WI 53706

                                   Ashish Tiwari
                               Department of Finance
                         Henry B. Tippie College of Business
                                 University of Iowa
                                Iowa City, IA 52242

Key words: Asset allocation, asset returns, business cycles, regime switching, business
cycles, volatility
                Asset Allocation under Alternative Economic Regimes

        It now accepted that both expected returns on assets and their volatility are time-
varying, perhaps driven by macro-economic factors and monetary policy. Moreover,
there is ample evidence of the existence of business cycles in the economy, where there
are periods of high volatility and low returns and periods of low volatility and high
returns. There is also an emerging consensus that the equity premium has fallen as well.
If these phenomena are exist, active portfolio managers should be able to exploit these
regimes to enhance portfolio performance either in terms risk premium or hedging
against economic downturn. Indeed, a received wisdom is that investors should seek
refuge in hard or safe assets, such as real estate, when economic downturn is expected.
What are the implications of these phenomena in terms of portfolio allocation decisions
of investors at different stages of the economic cycle? Is the optimal portfolio allocation
during economic downturn dominated by hard asset such as real estate?
        In this paper we examine how the investor‟s optimal portfolio allocation may
change based upon the state of the economy the investor is in. We rely on the regime
switching framework of Hamilton (1989) to model asset returns and the consumption
growth series as stochastic processes that are subject to change in means and covariance
due to shift in the underlying state of the economy or regime. Such a framework is well
suited to capture shifts in asset returns and consumption growth and any resulting
changes in portfolio allocations. We entertain several asset classes including small cap
stocks, medium and large cap stocks, real estate (equity REITs), commodities and
precious metals, international equities, Treasury bonds and corporate bonds.
        Our preliminary results are as follows. Asset returns and consumption growth
appear to be characterized by two regimes: a bad state where mean asset returns and
mean consumption growth rates are low and much more volatile, and a good state in
which mean asset returns and mean consumption growth are high and less volatile. More
importantly the results of our analysis clearly support an asset allocation policy that is
state or regime-dependent. The optimal tangency portfolio in the good state consists of
small cap stock (20%), medium and large cap stocks (48%), corporate bonds (8%), and
international equities (23%), with zero allocation to hard assets such real estate. In
contrast, in the bad state of economy the optimal tangency portfolio is exclusively
invested in equity REITs (42.51%), Treasury bonds (36.41%), precious metals (21.08%),
with zero allocation to equities. We interpret the dominant role of equity REITs in the
tangency portfolio in bad state as evidence of the hedging ability of real estate during
economic downturn.

Key words: Asset allocation, asset returns, business cycles, al estate, macro economic
factors, volatility

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