International Asset Allocation with Regime Switching: Evidence from the ETFs* Pan Jiang Institute for Financial Studies, Fudan University Qingfu Liu** Institute for Financial Studies, Fudan University Yiuman Tse College of Business Administration, University of Missouri – St. Louis Received 5 October 2014; Accepted 6 July 2015 Abstract We develop a dynamic investment strategy with Markov regime switching (MRS) in asset alloca- tion with international iShares exchange-traded funds (ETFs). Using daily ETF data, we show that a portfolio based on the dynamic MRS strategy outperforms one based on static mean-vari- ance strategies after transaction costs. This dynamic investment strategy not only captures the regime shifts in the highly frequent trading process but also can be practically used with tradable ETFs. We investigate the reasons for predictive misjudgments and assess the contribution of each regime’s investment strategy, providing insight into the characteristics of the MRS model and modifying our views on why the MRS strategy outperforms traditional strategies. Keywords Asset allocation; International ETF; Markov regime switching JEL Classification: C12, F31, G15 1. Introduction Various studies have shown that international equity markets exhibit higher volatility and correlations during market downturns than during market upturns. Several recent studies have considered these asymmetric effects while examining international asset allocation with Markov regime-switching (MRS) models (e.g., Ang and Bekaert, 2004; Guidolin and Timmermann, 2008; Kritzman et al., 2012; *We will thank the editor and anonymous referees for their insightful comments and sugges- tions. Liu acknowledges the supports from the National Nature Science Funds of China (71473042). This research started when Tse was visiting Fudan University. **Corresponding authors: Qingfu Liu, Institute for Financial Studies, Fudan University, Shang- hai, 200-433 Handan Rd, China. Tel: 86-21-6564-3821, Fax: 86-21-6511-2913, email: liuqf@ fudan.edu.cn. Asia-Pacific Journal of Financial Studies (2015) 44, 661–687 doi:10.1111/ajfs.12109 © 2015 Korean Securities Association 661