How regimes affect asset allocation

International equity returns are characterized by episodes of high volatility and unusually high correlations coinciding with bear markets. This article provides models of asset returns that match these patterns and illustrates their use in asset allocation. The presence of regimes with different correlations and expected returns is difficult to exploit within a framework focused on global equities. Nevertheless, for global all-equity portfolios, the regime-switching strategy dominated static strategies in an out-of-sample test. In addition, substantial value was added when an investor switched between domestic cash, bonds, and equity investments. In a persistent high-volatility market, the model told the investor to switch primarily to cash. Large market-timing benefits are possible because high-volatility regimes tend to coincide with periods of relatively high interest rates.