Follow up to VIX-based Pairs Trading Strategy
A refresher on strategy performance (red) vs the S&P 500 (grey) from 1989:
The concept behind the strategy is at least 3 1/2 years old. Links to others that came before me: Leistikow and Yu (academic paper, 2006), CXO Advisory (paper review, 2006), and CSS Analytics (mash up with our own Generals Lead the Troops analysis).
Strategy Losing Effectiveness?
Just eyeballing the chart, it’s pretty clear that the strategy as I described it has been less effective in recent history. To illustrate, the chart below shows the strategy’s rolling 5-year annualized return (blue, left scale) and volatility-adjusted return (red, right scale) from 1989.
Since about 2004, the strategy has failed to produce big results. At least part of that was likely a result of the low-volatility bull market of the mid-2000’s; it’s especially hard to generate market-neutral returns in a low-vol. environment.
But there was lot of volatility in the S&P 500/Russell 2000 pair during our most recent 2008-09 crises and yet still the strategy didn’t perform. That might be an indication that it has permanently lost some of its mojo.
Strategy Development Stuff (Warning: Extreme Geekery Ahead)
What this strategy needs to be really effective is an additional “moderator”, or put another way, another nifty observation that helps better refine the relationship.
Since the original post, I’ve been putting some time in to trying to understand just how to do that. Here’s where my equity curve stands today…
I was able to flatten out the big “shifts” in the original equity curve, particularly around 1998 and 2004, and produce a strategy with much more consistent results.
Unfortunately I can’t share my specific tweaks because I think this idea has the potential to eventually become one of our proprietary strategies, but I can say this…
This improvement actually had nothing to do with an additional moderator (that’s still to come). There’s a flaw in the logic of the strategy, as I originally described it, that’s related to the asymmetrical nature of the VIX. That flaw will cause the original strategy to lose market-neutrality, depending on the market regime in effect at that moment in time, creating bends in the equity curve that are NOT the result of the strategy gaining/losing effectiveness, but rather, the result of changes in the regime itself.
And that’s all I can say about that (sorry to be so vague). The strategy still needs additional work and it’s still waning in effectiveness, but I think the tweak above is definitely a step in the right direction.
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Filed under: Trading Strategies, VIX & Volatility | 11 Comments