What to Expect of Expected Dispersion

Dispersion signals the value of selecting individual stocks in an index as opposed to investing passively in the whole index. I analyze the determinant of the expected dispersion of a stock index, and the contributions of index components to dispersion. I find that dispersion decreases as correlations between stock returns increase, but that the effect of returns volatilities is ambiguous a priori. Stock with high weights and high volatilities contribute the most to expected dispersion. The offset between the impact of volatilities and correlations is consistent with some empirical results that show that dispersion varies in a narrow range for low or high correlations and volatilities. Dispersion only ventures out of this range during market crises