The case for setting up a Dispersion Strategy
In the past years, lowflation was highly supportive for markets. That occurred on the back of accommodative central bank policies. Unemployment levels and consumptions have now reached levels that have not been seen for years in many countries. With the overall growth outlook firming, consumer and business sentiments peaking, and corporate profits still holding steady, we expect that company forecasts may be more volatile than they were in the past. This is fertile ground to enter a dispersion strategy that takes advantage of diverging market movements.
What are the benefits and shortcomings of this strategy?
The difference between the implied volatility (expected volatility) of a quoted security and its subsequent realized volatility is well known, with volatility being the measure of the rate at which the price of a security increases or decreases for a given set of returns. Dispersion Strategy is a non-directional investment strategy aimed at capturing the absolute performance difference of the underlying universe; the dispersion is measured from the central point of the universe for each underlying security, and then added up.
Dispersion trading strategy is therefore, a type of correlation trading; in an initial portfolio set-up that is highly correlated, the underlying strategy of capturing the benefits of an increase in volatility is cheap. Trades are usually profitable during periods of stress (positive and negative, specific to a company or sector but not to the entire universe). When movements are highly correlated (equity-to-equity and equity-to-average-market), trades are less attractive. The composition of the investment universe is key; one can expect that companies which are at different points of the business cycle will perform better than a homogeneous universe. Additionally, the inclusion of a number of equities wherein analyst expectations for EPS growth and target price are highly inconsistent can improve return expectations.
The strategy requires access to both quantitative and qualitative methods that enable the grouping of financial instruments; the aim is to avoid overlapping risks, thereby providing customers with an improved level of diversification and an increased return opportunity.
The Dispersion Strategy is a non-directional investment strategy aimed at capturing the absolute performance difference of an underlying equity universe. Trades are usually profitable during periods of increased stress (specific to a company or sector, but not the entire universe). When movements are highly correlated (equity-to-equity and equity-to-average-market), trades are normally less attractive. The composition of the investment universe is key—a non-homogenous universe is expected to outperform one characterized by lack of diversity.
