Actively Using Passive Sectors to Generate Alpha Using the VIX

Abstract

A significant amount of academic research has documented momentum within and across broad sectors of the stock market as a means of generating alpha over a passive benchmark. However, few studies approach sector allocation from a mean reversion perspective using the Chicago Board of Exchange (CBOE) Volatility Index (VIX) as the trigger. We find that positioning into defensive sectors during periods of low volatility for the stock market, and into cyclical sectors during periods of high volatility produces significant long-term alpha. Using this framework, we back-test a dollar neutral strategy documenting return differentials, and create a modified S&P 500 Index that over-weights and underweights cyclical and defensive sectors systematically based on VIX levels. Absolute and relative returns for a sector allocation strategy that uses VIX levels significantly outperforms a passive buy and hold approach by using mean reversion to generate alpha. We postulate that the approach likely works because of behavioral biases related to loss aversion and the disposition effect creating mispricing that are repeatable and exploitable during periods of extreme market stress.