ETFs and index funds are contributing to higher correlations in the market and making it more difficult for investors to diversify their portfolios, according to an academic paper.
“The increased commonality of trading constituent stocks associated with index trading is consistent with a more synchronized market and, thus, rising levels of systematic risk. This, in turn, reduces the benefits of diversification across the equity market,” write Rodney Sullivan and James Xiong in a report on how index trading increases market vulnerability.
Sullivan is the editor of the Financial Analysts Journal at CFA Institute, while Xiong is a senior research consultant at Morningstar Investment Management.
“But index mutual fund and exchange-traded fund sponsors question the notion of whether it is the popularity of index products that is driving correlations or whether ETFs are simply an instrument for trading activities that could be driving correlations,” Ignites.com reports. [Are Rising Correlations Affecting ETF Diversification?]
For years, ETFs have faced allegations that they are responsible for rising correlations, and the so-called risk-on and risk-off trades when markets seem to moving in unison. [Stock ETF Correlations Returning to Normal]
However, some experts think ETFs are being unfairly blamed for markets moving in lockstep.