Q&A: S&PDJI Dispersion

Q&A: S&P DJI

From volatility to dispersion: capturing return spreads

Cboe and S&P Dow Jones Indices (S&P DJI) will be collaborating to develop the Cboe S&P 500 Dispersion Index.

Cboe and S&P DJI’s intent is to follow a similar approach on dispersion as they did with volatility. Like the Cboe Volatility Index (VIX), there will be a dispersion index based on the S&P500 (SPX) and then potentially futures and options, and so on. Tim Edwards (pictured), global head of index investment strategy at (S&P DJI), explains how the idea of developing the dispersion index came about.

“When in 1990 CBOE launched the VIX index, which is a forward-looking measure of market price of volatility or the market expectation of volatility, the market begun to understand volatility,” he says. “Then, in 2004, the first VIX futures contracts were listed and nearly 20 years later they have become a big part of the structured products trading investment ecosystem.”

The index methodology for the Cboe S&P 500 Dispersion Index has not been developed yet, and the two companies are “currently gathering feedback and insights from a wide range of market participants such as investment banks, structured products desks, options traders, and market makers to better understand their needs and the ways in which they will likely be utilising this index”. DISPERSION – THE CONCEPT All the 30 stocks comprising the Dow Jones Industrial Average have performed differently.

“There is a really widespread of returns from the best to the worst with a gap of about 30% - and there is a lot of risk of big movements in the stocks,” says Edwards.

However, all the risk is being diversified away at the index level, so the single stock risk is not translating into market risk.

“That's what dispersion does - it measures the spread of returns around the red line,” says Edwards. “You can also have a situation where the index kind of looks like one of the stocks. There's nearly just as much volatility in the index as there is in the stocks. In this case you are looking at low dispersion.”

Dispersion is a form of volatility, but it is different in that it is about the individual securities rather than the index.

“It looks at the realised standard deviation of returns, the spread of the stock returns,” says Edwards, adding that dispersion has been measured by the index business for years in the context of the opportunity set for stock selection for active managers.

“If there's a big difference between winners and losers, there's higher rewards to insight,” says Edwards. “Conversely, dispersion also measures the diversification benefit achieved by the index, compared to its constituents; it is the degree movement in stocks that is not reflected at the overall index.”

APPLICATIONS – APPEAL FOR ISSUERS Dispersion is not new and there is already a well-developed tradable market for this kind of trade - trading implied volatility in single stocks versus implied volatility on unique indices.

According to Edwards, many structured products issuers have open positions on products linked to single stocks. They can hedge index volatility with the VIX, but they are left with the difference between single stock volatility versus index volatility that circles dispersion trading.

“This makes hedging very lumpy, and it’s mainly done overthe-counter [OTC], with banks trading it with hedge funds or

Dow & Constituents - February 2021 Dow & Constituents - August 2015

Q&A: S&P DJI

Source: S&P DJI

volatility hedge funds,” he says. “What we are trying to do with this index is to bring a market standard that can be used as a reference point and as the basis for derivatives as happened with VIX.”

The index is not just aimed at options market makers and structured product issuers as there are plenty of other participants in the dispersion market.

“You have people who already have a position in dispersion, and they just want to manage and hedge that risk, but it can also be used for directional views. We expect investors to use the index to implement their directional views and how different market events are manifested in the dispersion,” says Edwards.

The two companies believe the index will resonate with exchanges and product providers as it will add value to investors and offer a new standard benchmark to the market to bring together market participants and give them ways to hedge, and to express views, including trading desks will be able to look at relative value in the option space on an index versus stocks basis.

“Until now, there has been no standardised S&P 500 version of this and that's what we're hoping to do.” says Edwards.

MARKET TRENDS One trend S&P DJI has identified towards the second half of the year is the increasing importance of the liquidity of the underlying which is a longer-term trend happening in the commodity markets with clients seeking more liquid instruments.

“There are concerns about liquidity elsewhere which has been emphasised by the recent events in the UK where we essentially had a liquidity crisis in gilts,” says Edwards. “When you have margin calls across the street, which can happen in a market downturn, liquidity becomes absolutely paramount.”

Other themes include sustainable investing which has opened opportunities around themes such as climate and biodiversity.

“This is a growth opportunity for us, and it is evolving,” says Edwards, “We are seeing growing interest from different parts of the market.

“ESG is a very interesting market where you have pulls in two directions – one around liquidity and transparency, and to keep things simple, and at the other end, we still have a lot of development and sophisticated innovation around sustainability-focused indexing strategies.”

The index provider remains “in a favourable position” to respond to demand for new themes and products as it seeks to capitalise on the merger with IHS Markit and the iBoxx Fixed Income Indices offering.

“We have got a long history of trying to build ecosystems around our indices – ETFs, futures, options, so that they have greater potential to offer liquidity when it is needed” says Edwards.