ETF Sector Rotation Trading Strategy – (VIX, Setup, Rules, Backtest, Results)

Crafting a strategy that adapts to changing conditions is crucial for success. One such strategy gaining attention is the ETF sector rotation trading strategy. In this case, we are going to be focusing on the Consumer Staples and Consumer Discretionary sectors. We make a unique twist to it: Utilizing the VIX level to inform rotation decisions. But does this work? Is it profitable?

Yes, it is possible to construct an ETF sector rotation trading strategy by using the VIX indicator. 

In this article, we will delve into the rationale, implementation, and potential benefits of this dynamic trading approach, and backtest a strategy of this type using the VIX as a signal trigger.

Related reading:

Understanding the ETF Rotation Strategy

An ETF rotation trading strategy involves dynamically adjusting investments among different ETFs based on specific market indicators or conditions. Let’s call them triggers. This strategy aims to capitalize on changing trends and offers several benefits:

  • Risk Management: Actively adjusting the portfolio in response to market conditions can help manage risk, especially during economic downturns. We define the market conditions in the trading rules. 
  • Adaptability: ETF rotation allows investors to adapt to different economic cycles, shifting investments to sectors expected to outperform in specific market phases.
  • Enhanced Returns: By timely rotating into sectors expected to perform well, investors seek to capture potential gains, potentially leading to enhanced returns.
  • Reduced Volatility: The strategy’s ability to avoid poorly performing sectors may contribute to reduced portfolio volatility.
  • Utilizing Market Trends: ETF rotation strategies aim to align investments with prevailing market trends, whether bullish or bearish.

That said, sector rotation strategies often tend to weaken over time.  

In the strategy we are going to backtest today, we will be using Consumer Staples and Consumer Discretionary sector ETFs. They have ticker codes XLP and XLY. 

Consumer Staples ETFs typically consist of stable, non-cyclical stocks, such as those in the food, beverage, and household product industries.

On the other hand, Consumer Discretionary ETFs encompass more cyclical sectors, including retail and entertainment.

The signal triggering the rotation of this strategy is the VIX. Often regarded as the market’s fear gauge, the VIX indicates higher market uncertainty when levels are high, leading investors to seek refuge in defensive sectors like Consumer Staples.

Conversely, lower VIX levels may suggest a more stable market environment, encouraging allocation to potentially higher-yielding Consumer Discretionary stocks.

Related reading:

Sector Rotation VIX Trading Strategy – Trading Rules

The strategy we are going to backtest was developed by Michael A. Gayed in his paper “Actively Using Passive Sectors to Generate Alpha Using the VIX.

The trading rules are very simple:

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For the backtest, we are going to be using the XLP and XLY ETFs. The data is adjusted for dividends and splits.

Here is the equity curve when we apply the trading rules:

ETF Sector Rotation VIX Trading Strategy
ETF Sector Rotation VIX Trading Strategy

The return looks good and is substantially higher than the buy and hold.

Here are some performance and metrics statistics:

  • CAGR was 9.20% (SPY buy and hold 7.21%)
  • Standard deviation was 22.55 (19.44)
  • Maximum drawdown was -59.05% (-55.19%)

The strategy performs better than the SPY although it carries higher volatility and drawdown, which was a bit surprising to us.

In Gayed’s paper, he backtested the strategy from 2005 to 2019 and obtained a better CAGR than we did.

Nonetheless, if we were to use the same timeframe as Gayed, our results would be very similar. Here are Gayed’s results:

His backtest shows a higher CAGR but with similar/sligthly higher levels of risk and drawdown than the SPY, pretty much the same that we find.

Why Does The Strategy Work?

A behavioral perspective highlights how cyclical sectors behave before stock corrections, influenced by the disposition effect. Winners in investor portfolios, often cyclical areas, are sold first during increased volatility, creating a mispricing effect exploitable post-spike in the VIX.

Implementing a defensive stance while waiting for cyclicals to present a buy-low opportunity poses challenges, as it requires forgoing aggressive positioning in potentially outperforming areas during defensive postures. Intuitively, being defensive pre-correction slows portfolio growth during bull markets but shields against overreaction in cyclical sectors during volatility spikes.

Sector Rotation VIX Trading Strategy – Conclusion

In summary, the ETF sector rotation trading strategy, influenced by VIX signals and inspired by Michael A. Gayed’s work, offers a dynamic approach to sector allocation.

We found results very similar to Gayed, despite backtesting a different time frame. This showcases the strategy’s potential advantages over traditional buy-and-hold methods due to its ability to navigate market uncertainties and capitalize on mispricing effects. 

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