Market Regimes, Sectorial Investments, and Time-Varying Risk Premiums

As an extension to the Fama and French three factor model (FF), this paper investigates the time-varying risk premiums of sector exchange traded funds (ETF) under a Markov regime-switching framework. In addition to the three style factors in the FF model, three macro factors: changes in market volatility, yield spread, and credit spread, are included in the proposed model. Using a maximum likelihood method, we categorize the economic market into three regimes: Bull, Bear, and Transition. We find all regimes are persistent with the bull market being the most persistent and the bear market being the least persistent over time.Risk premiums of the sector ETFs are highly regime dependent and the sensitivity of the funds to the risk factors are also regime dependent with positive or negative relations depending on the regimes. In contrast with the FF model, the proposed model yields substantial improvement in explaining the variation of the funds' returns using the selected six factors. Under the regime-switching framework, the sensitivities of the funds to the style and macro factors are shown to be more significant than the model without regime-switching