Asset allocation under stress - Learn to regime switch

There has been significant research on regime switching and asset allocation, but it has not been formally used by many investors. The reason for this lack of use has been simple. There have been few perceived major regime changes since the Great Financial Crisis. There has been a premium on keeping asset allocation simple and focusing on risky assets. The last five months suggest that managing assets under stress is not just critical but essential. When the world changes and there are tail events, allocations have to adapt.

There is some older accessible research for managing stress that can be easily implemented; see "Risk-based dynamic asset allocation with extreme tails and correlation" in the Journal of Portfolio Management, Summer 2012. The key take-aways from this work are twofold. One, focus on what is important for risk management, the CVaR, conditional value at risk or average shortfall given the VaR is breached. Two, model or focus on changing market regimes, in the simplest case, normal and extreme. The CVaR is dynamic and changes through time, but through using a regime switching model, these changes can be forecast. If you know or can measure the risk state of your portfolio, the allocations can be changed to reduce exposure to market extremes. 

The authors looked at a simple five asset portfolio, measured the CVaR through time and then developed a switching model to forecast the shortfall state. When the regime changes, the asset allocation is adjusted to some target CVaR level. Of course, when this is done with unbounded optimization, there can be extreme changes in the portfolio. The authors worked with a constrained optimization and found that there is still strong benefit from adapting to regime changes. A higher-level model will allow for more assets and a more sophisticated allocation process.

There can be different levels of allocation sophistication, but regime switching is now an accessible portfolio tool. However, even if there is some simple switching used with a nowcast model of financial stress, there can be improvements in asset allocation. Similarly, CVaR can be measured for a benchmark portfolio in a spreadsheet. The theory, tools, and data all make this type of asset allocation accessible and within the reach of most investors.