Abstract

The literature supports evidence of a contagion effect, where an increase in correlations and price movements is observed across assets during a market downturn. This contagion effect can diminish the diversification expected from a portfolio’s asset allocation. There is research showing a connection between capital flows and contagion. This thesis considers this connection through a dynamic allocation strategy with allocation decisions based on capital flow movements. This strategy is applied to an equity-only portfolio with the objective of maintaining some benefits of diversification while preserving capital. In an out of sample test, a regime switching model is used to predict market downturns for the period from January 1998 to December 2018. For the predicted downturns, portfolios’ geographical allocation is altered with allocation changes based on the countries’ capital flows. Results from historical back tests show weak evidence of higher returns and similar Sharpe ratios for a dynamic strategy versus a static strategy for portfolios of developed market equities. The implications for portfolios of emerging market equities are less obvious.