(Bloomberg) - The escalating conflict in the Middle East has jolted a popular hedge fund strategy, threatening a spillover into broader markets if volatility persists.
The dispersion trade — which uses options to exploit the difference between the volatility of a broader index and that of its individual components — has been a favorite with investors. The bet pays off as long as the S&P 500 Index continues edging higher while stocks keep churning beneath the surface, a market dynamic that has persisted for months.
But investors received a jarring wake-up call earlier this week, when the war in Iran sparked a bout of risk aversion. A measure of implied one-month correlation jumped to its highest level since November on Tuesday, with single stocks and indexes both tumbling.
Though correlations eased the following day when markets rebounded, the moves put investors in the strategy on high alert for further outbreaks of volatility.
“We could be at an important inflection point,” said Amy Wu Silverman, head of derivatives strategy at RBC Capital Markets. “One thing geopolitical events can trigger is a spike in correlation.”
In the dispersion trade, hedge funds typically buy options on individual stocks and sell them on the index.
Matthew Thompson, co-portfolio manager at Little Harbor Advisors, says there appears to be “crowded positioning” in the bet, making it more vulnerable to sudden unwinds if market conditions become less favorable. That could exacerbate a drop in broader indexes, as investors rush to exit similar positions at the same time.
“Anytime a lot of people are doing the same thing under the same assumptions and those assumptions then get tested, then absolutely you could see that kind of second-round effect,” he said.
A report underscoring economic resilience and cooling inflationary pressures drove stocks higher on Wednesday, even as the war in the Middle East clouded the growth outlook. The VIX, which tracks implied one-month S&P 500 volatility, fell to just over 21, down from a high of 28 earlier in the week.
“The US dispersion trade is a ticking bomb,” said Alexis Maubourguet, founder and chief investment officer of hedge fund Adapt Investment Managers. “But it’s not detonating today.”
Still, there are signs that Wall Street is preparing for more gyrations ahead. One of those, according to Little Harbor’s Thompson, was the appearance on Tuesday of an inverted VIX futures curve — suggesting that demand for hedges against near-term volatility is high.
One catalyst — besides the Iran war — could be mounting worries over credit markets, Thompson said. From Blue Owl Capital Inc. to Blackstone Inc., private credit funds across the industry are facing a wave of withdrawals and analysts are warning default rates could soar if artificial intelligence disrupts Corporate America as much as some market watchers expect.
“Credit issues can create these really high VIX levels and big liquidation type selloffs in the market,” he said. “That issue has not gone away.”
By Bernard Goyder
