A Hedge-Fund Volatility Trade Risks Crowd Crush Amid Tripled Assets

Key Takeaway

• The dispersion trade's popularity has surged, tripling assets in three years, driven by rising interest rates and market volatility.
• Increased entry costs and higher demand for index hedges are raising concerns about future profitability of the strategy.
• Some traders are now adopting reverse dispersion due to elevated entry points, reflecting shifts in market dynamics and strategy adjustments.

Dispersion Trade Popularity

The dispersion trade, once a niche strategy favored by hedge funds and volatility players, has grown significantly in popularity on Wall Street. Traditionally utilized by bank trading desks and fast-money players like Capstone Investment Advisors and One River Asset Management, the strategy has attracted new cash in the post-pandemic era, driven by rising interest rates that have boosted its performance. The strategy involves taking long and short positions to profit from differences between the volatility of an index, such as the S&P 500, and its individual components. According to Guillaume Flamarion, Citigroup Inc.’s head of the Americas multi-asset group, assets in the strategy have potentially tripled over the last three years.

Vincent Cassot, head of equity derivatives strategy at Societe Generale SA, noted, “It’s a bit of a victim of its own success. The bar is quite high for the trade to be profitable going forward.” The strategy typically involves selling options on a broad equity gauge like the Nasdaq 100 while buying similar derivatives on individual stocks like Nvidia Corp. or Tesla Inc. This approach capitalizes on the higher demand for index hedges from investors seeking portfolio insurance, which generally results in higher prices for protection at the benchmark level compared to the stock level.

Rising Costs and Market Dynamics

The increasing popularity of the dispersion trade has led to higher entry costs, raising concerns about future profitability. Stephen Crewe at Fulcrum Asset Management, who has been trading dispersion for two decades, mentioned that he is now receiving questions about whether it is too late to enter the trade. “These days there are all these multi-managers who have multiple groups of people within the fund looking at the trade,” Crewe said. Banks are also offering quantitative investment strategies (QIS) that mimic the dispersion trade, with the number of QIS targeting dispersion increasing by 75% since the end of 2021, according to PremiaLab data covering 18 banks.

Xavier Folleas, head of QIS at BNP Paribas SA, explained that the trade has grown because it is seen as a cheaper form of portfolio insurance. “Dispersion really is the sweet spot,” Folleas said. The strategy benefits from individual stocks moving significantly while the index remains relatively stable. This has been the case in recent years, with the average volatility of S&P 500 members reaching its highest level versus the index since at least 2011, according to SocGen data.

Market Volatility and Strategy Adjustments

Despite the growing popularity of the dispersion trade, overall volumes in the US options market have doubled since 2019. The trade remains well-positioned to benefit from the volatility of large-cap stocks like Nvidia, Tesla, and Meta Platforms Inc., which have experienced significant one-day moves. These idiosyncratic swings have reduced correlation across S&P 500 names, further supporting the dispersion strategy. However, the entry point for the strategy has become so elevated that some traders, like Crewe’s team, have flipped the trade to buy index options and sell single-stock options, known as reverse dispersion.

A PremiaLab index that aggregates QIS dispersion trades has been relatively flat this year, following a 2% loss in 2023 and a 13% gain in 2022. Despite the challenges, Flamarion from Citi noted, “There are fewer opportunities to size it up than there used to be two years ago. But it’s something people are keeping in their portfolios.”

Street Views

• Vincent Cassot, Societe Generale (Neutral on dispersion strategy):

  "It’s a bit of a victim of its own success. The bar is quite high for the trade to be profitable going forward."

• Stephen Crewe, Fulcrum Asset Management (Cautiously Optimistic on dispersion strategy):

  "These days there are all these multi-managers who have multiple groups of people within the fund looking at the trade. And now you’re in a position where your banks are offering it as these quantitative investment strategies."

• Xavier Folleas, BNP Paribas SA (Bullish on dispersion strategy):

  "Dispersion really is the sweet spot."

• Guillaume Flamarion, Citigroup Inc. (Neutral on dispersion strategy):

  "There are fewer opportunities to size it up than there used to be two years ago. But it’s something people are keeping in their portfolios."