(Bloomberg) -- A popular hedge-fund trade betting on calm is reloading after the equity selloff, even as some critics warn it helped fuel the recent turmoil.
Once a niche strategy for specialized hedge funds, the so-called dispersion trade has boomed in the bull market era — netting big gains by riding placid equity indexes while wagering that volatility will hit underlying companies.
Last week’s market drama briefly upended the wager. One proxy for the trade slid 1.7% over two sessions through Aug. 5 in its worst performance since October 2021, according to a LumRisk index that aggregates bank swaps known as quantitative investment strategies, or QIS.
The gauge subsequently rebounded in each of the following four days, trimming its month-to-date loss through Friday to a meager 0.2%. As calm returns to Wall Street, derivatives pros say the market disruptions are offering an entry point for opportunistic traders with the appetite to bet against future equity price swings, known as short volatility.
All this is notable given the dispersion trade was cited by Rocky Fishman, founder of derivatives analytical firm Asym 500, for contributing to last Monday’s volatility spike, a scenario rejected by the Cboe Global Markets Inc. And it suggests the trade is likely to remain crowded until the next market blow-up — but one that proves more enduring than last week’s VIX spike.
“If you want to look at it on the positive side, it’s not ended up that bad and it has flushed out a little bit of the complacency that was in the market,” said Giulio Alfinito, global head of QIS structuring at UBS Group AG.
Dispersion generally benefits when individual stocks move around a lot but cancel each other out to keep the index steady. In early August, an unwind of the yen-based carry trade, worries about the US economy and doubts about the valuations of major tech shares combined to spark a selloff. The volatility of the S&P 500 climbed to the highest level since October 2022, while the correlation of its members jumped to a nine-month high.
While they remain notably higher than lows posted in July, both measures have since subsided.
As a consensus emerges that Monday’s tumult was no regime shift in markets for now, Kris Sidial, a widely followed derivatives expert at the tail-risk hedge fund Ambrus Group, said on the social media platform X that many traders have doubled down on the trade. That’s after recouping most of last Monday’s “catastrophic mark-to-market losses.”
Fulcrum Asset Management was among firms to boost wagers on dispersion amid Monday’s tumult. Still Stephen Crewe, head of volatility strategies, reckons the rupture ultimately only presented a short window of opportunity. His fund briefly had its worst run of losses since November 2021, but has since trimmed its August decline to 0.6%.
“There are investors out there who were looking at starting the strategy out and they were hoping for from a much bigger move than we saw,” he said.
To Scott Maidel, head of hedge fund business at the $2 billion volatility shop QVR Advisors, the turmoil shook out some leveraged weak hands. Yet he warns investors buying into the trade now face trouble. QVR bet against the strategy during the first quarter, but the wager didn’t pan out as dispersion between stock and index volatility kept widening, so the firm exited its position.
“In the event of a market distress, you stand to lose much more on the short index” side of the trade, he said. “We remain cautious.”
Alexis Maubourguet, chief investment officer at ADAPT Investment Managers SA, echoes the view. He warns that stock correlations — which capture the price of entering the dispersion trade now — remain too low to be sustainable given the fact investor positioning hasn’t materially shifted.
“I would tend to think that we haven’t seen capitulation because there hasn’t been a clearing level where the shorts are being bought back and the longs are selling back to the shorts,” he said.
--With assistance from Tracy Alloway.
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