Investment implications of this regime:1
Security level — Both the cross-sectional dispersion and the cross-sectional correlation between global equity securities were lower than normal. In other words, equities tended to be less volatile relative to each other and less correlated.
Sector level — Perhaps related to the security-level point above, the relative sector performances did not follow the usual pro-cyclical or anti-cyclical patterns; instead, we saw outperformance by sectors that are typically able to pass on inflation, such as energy, utilities, and real estate.
Factor level — This regime’s lack of discrimination with regard to risk was evident in the performance of the risk-aversion and risk-seeking factors, with no clear bias between them within equities or credit, and with both producing a distribution of excess returns broadly around zero.
What’s the use case? Positioning for portfolio resilience, rather than regime timing
To summarize, our behavior-based research shows that markets have naturally fluctuated between four regimes, with risk-on regimes offering the most positive return-to-risk profile, followed by nervous regimes, with still-strong returns but also elevated volatility. Risk-taking was not rewarded in panic regimes, while uncertain regimes were characterized by muted results across the board.
While it may be tempting to use this analysis to position a portfolio for a regime transition, we think this would be challenging given the uncertainty over both the length of a regime and the nature of the subsequent regime — as shown in Figure 1, there was no clear pattern in the regimes over time. Instead, we think asset allocators would be better served by spending their time understanding how their portfolio is likely to behave during each of these regimes and ensuring that it is constructed so that it will be resilient enough to hold up in any potential environment.
When building portfolios, allocators are generally comfortable employing geographic diversification, asset class diversification, and even some factor diversification. But allocators are generally not diversified across regimes, with portfolios often designed for a single specific set of conditions. We think our research in this area could help allocators build a more well-rounded understanding of regimes and construct more diversified and robust portfolios.