Quantitative tactical asset allocation: Using the VIX to exploit bull and bear market movements in a Mean-Variance portfolio

Abstract

The Chicago Board Options Exchange (CBOE) Volatility Index (VIX) is known as being an indicator of fear, often referred to as the fear index. Low volatility indicates tranquility in the market, whereas high volatility indicates distress. We aim to use the level of the VIX as an indicator for stock market movements and incorporate it into an investment strategy within a Markowitz (1952) mean-variance (MV) setting. By using Kenneth French's 12 industry assets over a 30-year window, we calculate the sensitivity between VIX and the assets. Further, by incorporating transaction costs, and testing for different input variables for the strategy, we build upon earlier papers by Copeland and Copeland (1999), and Cloutier, Djatej, and Kiefer (2017). The VIX strategy is tested against a simple moving average (SMA) strategy suggested by Faber (2013). We find evidence in suggesting that our VIX strategy, using MV as the outset portfolio, outperform the buy-and-hold strategy as well as the SMA strategy. Additionally, after introducing an equally weighted outset portfolio, the strategy is able to outperform the S&P 500 over the 30-years.