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Wall Street’s dispersion trade surge sparks fears of overcrowding and diminishing returns

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Dispersion, a strategy that has traditionally been the domain of bank trading desks and fast-money players like Capstone Investment Advisors and One River Asset Management, has attracted significant new investment in the post-pandemic era, according to a report by Bloomberg. 

The strategy’s popularity has been driven by a market characterised by rising interest rates, which have boosted its performance, Bloomberg reported. 

Dispersion trading involves taking long and short positions to profit from differences between the volatility of an index like the S&P 500 and similar derivatives on individual stocks like Nvidia or Tesla. The aim is to capitalise on the typically higher demand for index hedges from investors seeking portfolio insurance, who usually pay more for this protection at the index level than it costs to hedge individual stocks.  

Estimating the exact growth of the dispersion trade is challenging. Guillaume Flamarion, head of the Americas multi-asset group at Citigroup, said that he believed assets in the strategy have at least doubled, possibly tripled, over the past three years. However, rapid growth threatens to erode the arbitrage opportunity central to the strategy. 

Vincent Cassot, head of equity derivatives strategy at Societe Generale, called the strategy “a victim of its own success” and said that the bar would have to be “quite high for the trade to be profitable going forward”. 

The ideal conditions for dispersion trades occur when individual stocks exhibit significant volatility, increasing the value of purchased options, while the index remains relatively stable, reducing the value of sold options. According to SocGen data, the average volatility of S&P 500 components is now the highest relative to the index since at least 2011. 

This environment has been beneficial for those already invested in the trade, but for those entering the strategy, the cost has reached its highest point in at least 13 years, making it increasingly challenging to generate profits. 

Stephen Crewe, a partner at Fulcrum Asset Management said that he was frequently asked about whether it is too late to enter the market, noting the increased attention from multi-managers and that banks had started offering the trade as quantitative investment strategies. 

QIS, a type of structured product created by banks to mimic quant strategies, have become popular due to its transparency and cost-effectiveness. The number of QIS targeting dispersion has risen 75% since the end of 2021 to over 50, according to PremiaLab data from 18 banks. UBS Group, for example, is preparing a new offering after inheriting one from Credit Suisse Group. 

Xavier Folleas, head of QIS at BNP Paribas, attributed the growing popularity of dispersion to it being perceived as a more affordable form of portfolio insurance. 

Despite the influx of money into dispersion trades, overall volumes in the US options market have doubled since 2019, Bloomberg reported. The strategy theoretically remains well-positioned to benefit if the era of the “Magnificent Seven” continues, given that these frequently exhibit significant one-day moves unlike historic blue-chips, providing the volatility dispersion strategies thrive on. 

As these swings are often idiosyncratic, the correlation among S&P 500 stocks has fallen to its lowest level in at least 13 years, according to Bloomberg’s data. This reduction in correlation benefits dispersion strategies, as many price movements cancel each other out at the index level. 

Flamarion said that while there were “fewer opportunities to size it up than there used to be two years ago”, dispersion was still “something people are keeping in their portfolios”. 

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