Understanding Dispersion And The Cboe S&P 500 Dispersion Index

October 31, 2024 at 08:25 AM EDT

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By Cboe, Benzinga

The Cboe S&P 500® Dispersion Index (DSPXSM) debuted over a year ago, but the investment concept of dispersion still remains unfamiliar or unclear to many investors. In simple terms, dispersion refers to the range or spread of individual stock returns around the index’s average return. Each day, indices like the S&P 500 calculate a market-cap-weighted average return based on the performance of the stocks within the index. However, this average does not reveal the variation in returns between individual stocks, which is where the concept of dispersion becomes relevant. Dispersion measures this variation, highlighting the potential opportunities for stock selection. Understanding dispersion is helpful for portfolio managers engaged in active management or individual traders because it reflects the potential payoff for selecting stocks that outperform the average.

The Value Proposition Of Dispersion

During periods when there’s more distance between the best- and worst-performing stocks, a portfolio manager or trader can add more value by picking the best stocks and avoiding the worst. Thus, dispersion is a means of quantifying one’s stock selection ability.

In a relatively lower dispersion environment where stocks generally move in tandem, an active investor will find it especially difficult to construct an index-beating portfolio. In such circumstances, the case for passive investing is typically highlighted. However, in a high-dispersion environment, one should expect a relatively wide range of returns, increasing the probability of profiting more.

The Relationship Between Dispersion And Volatility

Given that dispersion is a measure of magnitude, intuitively, one would assume that periods of high dispersion would be accompanied by increased volatility. In actuality, dispersion has been present in both bull and bear markets. As detailed in S&P Dow Jones Indices’ whitepaper, Dispersion: Measuring the Market Opportunity, between April 1999 and January 2001, there was a material increase in dispersion for the S&P 500 Index, driven by the industry behavior of the technology sector. However, index volatility did not rise, as sectors other than technology performed more normally. The takeaway was that dispersion can better capture periods where only a portion of the market either bubbles or crashes.

There have also been instances where volatility has been elevated, but dispersion has been low. During the summers of 2010 and 2011, volatility surged without a corresponding increase in dispersion. Individual stocks performed similarly as market participants responded indiscriminately to events like the European debt crisis and the U.S. government debt downgrade.

The Cboe S&P 500 Dispersion Index Explained

The Cboe S&P 500® Dispersion Index (DSPX℠) measures the expected dispersion in the S&P 500® over the next 30 calendar days, as calculated from the prices of S&P 500 index options and the prices of single stock options of selected S&P 500 constituents, using a modified version of the VIX® methodology.

In contrast to "realized dispersion" – a measure of independent movement observed in the components of a diversified portfolio – the Dispersion Index is a forward-looking implied measure. The index may provide an indication of the market's perception of the near-term opportunity set for diversification or, equivalently, an indication of the market's perception of the near-term intensity of idiosyncratic risk in the S&P 500's constituents.

How Dispersion Can Work For You

The Cboe S&P 500 Dispersion Index offers several advantages, the primary one being that it measures the variation in individual stock returns within the S&P 500, helping active investors spot potential stock-picking opportunities. By understanding how much individual returns differ from the average, active investors can gauge the potential rewards of selecting better-performing stocks. The index also helps with risk management by showing periods of greater or lesser market dispersion, which can guide trading and portfolio decisions. For traders, it offers insights for using options or hedging strategies based on market volatility. Overall, it provides a clearer picture of market behavior beyond just the average return.

Featured photo by Anne Nygård on Unsplash.

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