How Volatility Regimes Affect Sector Rotation Strategies

Abstract

Volatility regimes are a core aspect of financial market activity that not only affect the way they allocate assets but also determine the rotation strategies of the sector used by institutional and retail investors. This paper analyzes the effects of the changes of the low, moderate and high volatility regime on the relative performance of both defensive and cyclical sectors, carry implication on portfolio diversification, and risk-adjusted returns. Using the available theoretical frameworks, and empirical studies, the analysis will use the regime-switching framework and sectoral performance measures to evaluate the consistency and reliability of rotation strategies during different market conditions. Results show that defensive industries like utilities and consumer staples are robust in volatile settings, but those with cyclicality like technology and consumer discretionary are well-performing in stable and expanding times. The paper highlights the necessity of considering volatility regime tracking in tactical asset allocation to reduce downside risk and to realize sector or industry-specific opportunities. Moreover, the findings demonstrate the possible traps of excessively making use of the historic correlations, the continuously changing character of market structures and investor mood. This study helps understand better, by filling the gap between academic theory and the investment practice, how volatility regimes are the key factor to the sectoral change, and provide valuable information to portfolio managers who want to maximize strategies in the market that are becoming more and more uncertain.