Combining a Regime Switch with Sector ETF investing

Feb 05, 2025 in Regime Change, Sectors

The performance of different industrial groups will vary over the course of the business cycle. Consequently, it makes sense that sector allocations be revised when there is a change in the prevailing regime.

Below is an example that uses High Yield Bonds to define the market regime.¹  When JNK is trending upwards (i.e. above its MA), the backtest invests in the following high Beta sectors;  Financials (XLF), Industrials (XLI), Technology (XLK) and Consumer Discretionary (XLY).  Conversely, when the JNK trends down (i.e. below its MA), the backtest switches to a portfolio of low volatility defensive sectors; Consumer Staples (XLP), Utilities (XLU) and Health Care (XLV).  To keep things simple, both the high Beta and low volatility portfolios are equally weighted.²

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A simple alternative to choosing specific sectors from within an index (in this case the S&P 500), is to increase the leverage of the index itself when in Risk On mode or add cash when Risk Off. The following example employs the same High Yield regime, but this time the high Beta portfolio is 75% SPY and 25% SSO (2x daily S&P 500 return) and defensive portfolio is 75% SPY and 25% BIL.³

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This simpler strategy produces far fewer trades. It should also be noted that as the high Beta and defensive portfolios are now just mildly levered / diluted versions of SPY, they will both be (almost) perfectly correlated with the S&P 500.   While this could be considered a drawback, high-correlation to strong performing assets in up markets is consistent with Risk On strategy’s objective. The lack of diversification is less than ideal for the defensive portfolio, but the significant cash allocation will cushion losses in down markets.⁴

Notes:

1. XZERO is simply a zero return index (i.e. it's a constant), so a 6-month MA of the ratio JNK / XZERO is the same as a 6-month moving average of JNK itself.
2. An equal weight allocation will mean that sectors are over, or under, weight relative to their market capitalization weightings.  Over the last 20+ years,  the market cap value of the Health Care sector has been approximately 4 times that of Utilities. An allocation of XLP 35%, XLV 52% and XLU 13% would therefore be more in line with market capitalization weights.
3. (75% * 1.0) + (25% * ~2.0) = ~1.25 Beta. (75% * 1.0) + (25% * ~0) = ~0.75 Beta
4. Both examples employ a 6-month moving average to define the regime. When relying on any particular MA length there is always the risk that it will underperform in the future, even though it performed well in backtests. This risk can be attenuated by diversifying across a range of moving average lengths.

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