Hedge Fund Diversification Strategies: New Approaches in a Volatile Market Environment

For Hedge Funds, Last Year’s Popular Index Dispersion Strategy Is Evolving Into More Focused Plays

As “tariff tantrums” shake global markets, macroeconomic concerns have taken center stage, overshadowing company-specific news. In April, implied correlation for the S&P 500 index reached its highest average level in more than two years and remained elevated even during earnings season. A similar trend was seen in Europe.

Ordinarily, this would hurt returns from so-called dispersion strategies—which bet on the volatility differences between an index and its components. But this time, it didn’t. Seasoned investors moved away from broad indices and instead focused on smaller, hand-picked baskets, allowing them to profit from the trades.

“Despite the recent spike in correlation, dispersion trades have been profitable in recent months because the baskets appeared to be concentrated in names with higher realized volatility,” said Michalis Onisiforou, flow derivatives strategist at Banco Bilbao Vizcaya Argentaria SA. In Europe, volatility arbitrage traders have been locking in gains recently by closing out positions in names with the highest realized volatility amid falling implied levels, he added.

A hypothetical basket comparing the volatility of selected Swiss financial firms to that of the Swiss Market Index showed that the gap in realized volatility widened in April, according to Bloomberg data—delivering profits for anyone who used the strategy.

Even though the three-month implied correlation for the S&P 500 fell from earlier highs in April, the average for the month was nearly double the one-year average. Quantitative investment strategies—some of which seek to profit from dispersion—were highly active in the market. Those focused on dispersion performed “very well,” according to Adrien Géliot, CEO of Premialab, a firm tracking QIS strategy offerings.

Defensive dispersion setups were already popular before April 2 but have become even more relevant in today’s volatile environment. For active management, JPMorgan strategists recommend techniques for managing correlation shocks, including partial intraday hedges on the short volatility leg or layering in long volatility positions via VIX or VStoxx option structures.

Bank of America strategists point out that tariff threats to the global economy are artificial and reversible, making left-tail risks (deep losses) less likely in the absence of external shocks. Last week, they recommended a more aggressive dispersion structure with a bias toward short volatility.

The abundance of volatility selling strategies also seems largely unaffected by tariff-driven turmoil. Some tactical multi-strategy funds capitalized on elevated volatility levels in early April, entering so-called carry trades—short volatility positions. Funds that timed their entries well booked double-digit gains in just a few days as volatility quickly dropped, according to Géliot.

However, the recent decline in volatility suggests the environment is shifting. According to Antoine Porcheret, head of institutional structuring for the UK, Europe, Middle East, and Africa at Citigroup Inc., carry trades are now more focused on fixed-strike options. As a result, equity market volatility has calmed significantly.

“Selling volatility is increasingly being done in a way that limits risk,” he said. Dealers are less exposed to changes in volatility, so “we may now see weaker volatility reactions during market declines, as was the case before Covid—or any spikes may be shorter-lived,” he added.