I’m extremely pleased that the latest paper I co-authored alongside my friends David Dierking and Matthew Bowler, “Actively Using Passive Sectors to Generate Alpha Using the VIX,” was declared the winner of the NAAIM 2020 Founders Award for Advances in Active Investment Management and a Finalist for the 2020 Dow Award. It topped nearly 30 other entries and became the 5th award-winning paper I’ve co-authored over the past several years.
This one is a little different than the prior four papers I’ve co-authored. The risk signals I follow and publish weekly for Lead-Lag Report subscribers (www.leadlagreport.com) look at intermarket behavior to determine whether you should be positioned risk-on or risk-off in response to market conditions. The VIX paper doesn’t designate between risk-on and risk-off, although it does propose three different trading strategies based on optimized VIX levels and publishes their results. Some of the sector rotation strategies we tested produced compelling results, both on an absolute and risk-adjusted basis.
It also identifies what forward-looking market returns have been historically across individual sectors and the equity markets as a whole, based on the VIX level at the time. In essence, using history as a guide, it tries to answer the question of which segments of the market tend to outperform and underperform over various time frames using the VIX as an entry point signal. More importantly, how can it be exploited for gain?
At the 30,000-foot view, our primary discovery was this: Most people tend to feel comfortable buying stocks when market conditions are calm and sell when the markets turn volatile. Our research concluded that investors should do the exact opposite.
The logic behind our research is actually fairly straightforward. It’s a spin on the traditional buy low, sell high strategy and indicates that investors should be buying equities (or, conceivably, other risk assets) when volatility levels are excessively high and sell when volatility is excessively low.
Why? Spikes in the VIX are almost always associated with sharp and severe downturns in the markets. This can best be explained in the paper’s conclusion.
“While momentum is often touted as the ideal anomaly to take advantage of using sectors to express an active bet on continued performance, we find that an approach which waits for momentum to crash with a VIX spike allows for an ideal set-up to buy low and sell high when investor overreactions take place.”
As the VIX rises, stock prices tend to fall and investors, in general, tend to overreact. These types of scenarios create opportunities for smart market watchers to exploit and generate alpha. This was our general thesis. By adding risk to your portfolio when volatility levels were high, investors would essentially be buying stocks “on sale”. Positioning your bets in the right sectors also amplified the opportunity to achieve superior results.
High Level Results
We generated our back test looking at the rolling 14-day VIX on any given trading day (in order to smooth out some of the short-term noise) and measuring the forward-looking performance over several time periods.
The results are compelling.
In summary, investing in almost any sector when VIX levels are at their lowest yielded the poorest forward-looking returns. Conversely, investing when volatility levels are at their highest produced the best longer-term results.
Some of the other findings make intuitive sense, as well. Cyclicals and growth areas of the market performed best coming out of a VIX spike. In theory, these sectors will likely have underperformed during the high volatility period, but subsequently outperformed on the rebound. The traditionally defensive sectors – consumer staples, healthcare and utilities – delivered the worst returns for the opposite reason.
At low VIX levels, however, utilities and consumer staples were outperformers. Presumably, this would be because a period of extreme calm precedes a volatility spike, in which defensive issues likely fall less than the market.
Historically, tech outperforms in all scenarios because, well, it’s the tech sector!
Implementing VIX Strategies in Your Portfolio
In the paper, we offered a number of different scenarios in which investors could implement the VIX strategy. We proposed various weightings of cyclical and defensive sectors based on pre-specified VIX levels. One such proposal allocates 100% to a cyclical index in high VIX environments and rotates to a 100% defensive index in low VIX environments using optimized trigger entry and exit points.
The returns on both an absolute and risk-adjusted basis are impressive. The strategy produced about the same level of risk as the S&P 500, but generated anywhere from 2.6% to 3.9% in additional annualized return. On top of that, it captured more upside and less downside than the broader market.
This sector rotation strategy we tested resulted in significant long-term performance. It initially performed about on par with the broader market during the financial crisis, but from there, it remained consistently ahead of the S&P 500. One particularly interesting finding was that these superior risk-adjusted returns were achieved by being invested in the defensive index more often than not. The risk mitigation factor of these lower-than-average risk factors was the factor that pushed risk-adjusted returns over the top.
We were particularly excited that the discovery of this contrarian signal could produce superior risk-adjusted returns for investors by moving against the financial market groupthink. We’re pleased to be able to share the latest piece of award-winning research with you.
To download the paper and my prior work, look up Michael Gayed on SSRN.com, and feel free to get 30% off The Lead-Lag Report at www.leadlagreport.com with Promo Code LeadLag30.
