(Bloomberg) — A once-niche stock trade beloved by hedge funds and volatility players has ballooned into one of the biggest options strategies on Wall Street, stirring fears it will get crushed by its own popularity.
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Known as dispersion, it’s traditionally been the preserve of bank trading desks and fast-money players like Capstone Investment Advisors and One River Asset Management. But it’s been luring new cash in the post-pandemic era as a market riven by rising interest rates has boosted performance.
The approach pairs a long and short position to profit from differences between the volatility of an index like the S&P 500 and that of its individual members. By one estimate, assets in the strategy have as much as tripled in three years. That threatens to erode the arbitrage at the heart of the wager, and has left industry pros fretting over the prospect of diminishing returns ahead.
“It’s a bit of a victim of its own success,” said Vincent Cassot, head of equity derivatives strategy at Societe Generale SA. “The bar is quite high for the trade to be profitable going forward.”
The investing style sells options on a broad equity gauge like the Nasdaq 100 while buying similar derivatives on individual components of the gauge like Nvidia Corp. or Tesla Inc. The idea is to ride the relatively higher demand for index hedges from investors seeking portfolio insurance, which means they typically pay more for protection at the benchmark level than it costs the trader at the stock level.
The perfect conditions for the trade would see individual stocks move around a lot — making the purchased options more valuable — but largely canceling each other out to keep the index steady, making the sold options less valuable. That’s exactly what’s played out in the last three years as benchmark rates have risen. According to data compiled by SocGen, the average volatility of S&P 500 members is now the highest versus that of the gauge since at least 2011.
All this is good news for anyone already in the trade. But as investors bet on the pattern continuing, the cost of entering the strategy now is similarly at the highest in at least 13 years, raising the bar to make money ahead.
Stephen Crewe at Fulcrum Asset Management, who has been trading dispersion for two decades, says he’s now fielding questions about whether it’s too late to get in.
These days there are “all these multi-managers who have multiple groups of people within the fund looking at the trade,” the head of volatility strategies said from London. “And now you’re in a position where your banks are offering it as these quantitative investment strategies.”
QIS are a form of structured product created by banks to mimic quant strategies that have boomed in recent years thanks to their transparency and cheapness. The number of QIS targeting dispersion has jumped 75% since end-2021 to more than 50, according to PremiaLab data covering 18 banks. UBS Group AG, for instance, is readying a new offering after inheriting one from Credit Suisse Group AG.
The trade has kept growing because it’s seen as a cheaper form of portfolio insurance, according to Xavier Folleas, head of QIS at BNP Paribas SA. The single-stock options it buys gain in value if equities plunge, but even when markets are quiet it make some money from selling index volatility.
“Dispersion really is the sweet spot,” Folleas said.
It’s hard to know exactly by how much the dispersion trade has grown. In the estimate of Guillaume Flamarion, Citigroup Inc.’s head of the Americas multi-asset group, assets riding the strategy have at least doubled and possibly even tripled over the last three years.
That’s coincided with a period of falling index volatility. The Cboe Volatility Index, a gauge tracking the cost of S&P 500 options known as the VIX, hit a fresh five-year low Thursday — a telltale sign of weak hedging demand. Some analysts say the self-fulfilling feedback loop of option-selling strategies, including dispersion, contributes to the calm.
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The classic strategy itself comes in various guises — for instance some approaches buy more options than they sell or vice versa. But over the past year, the entry point for the strategy has at times become so elevated that Crewe’s team has flipped it around to buy index options and sell single-stocks ones, in what is known as reverse dispersion.
A PremiaLab index that aggregates QIS dispersion trades is just about flat this year, after a 2% loss in 2023 and 13% gain in 2022.
Still, while there’s more money chasing dispersion, volumes in the US options market overall have doubled since 2019. And the trade theoretically remains well placed to benefit if the era of the Magnificent Seven lives on.
Unlike the mega-caps of yore like General Electric Co. or Procter & Gamble Co., American blue-chips these days regularly offer investors a roller-coaster ride. The likes of Nvidia, Tesla and Meta Platforms Inc. have each posted one-day moves of at least 10% over recent months, handing dispersion strategies the volatility they crave.
Yet since these swings are largely idiosyncratic, correlation across S&P 500 names has also fallen near the lowest in at least 13 years, Bloomberg data show. That also helps dispersion, since many moves cancel each other out at the index level.
“There are fewer opportunities to size it up than there used to be two years ago,” said Citi’s Flamarion. “But it’s something people are keeping in their portfolios.”
–With assistance from Lu Wang.
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