How Do Regimes Affect Asset Allocation?
Coauthor(s): Geert Bekaert.
Everyone who has studied international equity returns has noticed the episodes of high
volatility and unusually high correlations coinciding with a bear market. We develop quantitative
models of asset returns that match these patterns in the data and use them in two quantitative
asset allocation analyses. First, we show that the presence of regimes with different correlations
and expected returns is difficult to exploit with within a global asset allocation framework focussed
on equities. The benefits of international diversification dominate the costs of ignoring
the regimes. Nevertheless, for all-equity portfolios, a regime-switching strategy out-performs
static strategies out-of-sample. Second, we show that substantial value can be added when the
investor chooses between cash, bonds and equity investments. When a persistent bear market
hits, the investor switches primarily to cash. This desire for market timing is enhanced because
the bear market regimes tend to coincide with periods of relatively high interest rates.
Source: Financial Analysts Journal
Bekaert, Geert, and Andrew Ang. "How Do Regimes Affect Asset Allocation?" Financial Analysts Journal 60, no. 2 (2004): 86-99.