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Out performance analysis by Hidden Markov Model
Abstract
A persistence of the performances of mutual funds over mean-term horizons is observed on the market. This persistence was attributed to “hot hands” effects: some mutual funds outperform because they hold relatively larger positions in last year’s winning stocks and not because they have some stock-picking skills. The problematic is how to take into account the capacity of a mutual fund to reach a state of outperformance relatively to other mutual funds. By using hidden Markov chains, we quantify this capacity with characteristic times. The proportion of future outperforming mutual funds in a portfolio can be increased if these times are adequately used in the selection process.