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.
“These are volatile times in our markets. In difficult times it is natural to look for a cause that can be easily identified and even fixed. Exchange traded products are a tempting target,” said Eric Noll, head of transaction services at Nasdaq OMX, in a Senate subcommittee hearing on ETFs last year.
“But restricting or eliminating the ETP business will not solve the sovereign debt crisis in Europe, will not balance the U.S. budget, will not restore bank balance sheets, will not add jobs, and will not repay consumer debt and get them spending again,” Noll added. “There are very large, very real uncertainties that are driving global financial market volatility.”
The paper from Sullivan and Xiong does admit that the rise of index trading is only one possible contributor to an increase in correlations, Ignites reported this week.
“It’s curious to me to think that a group of funds that accept the price set for securities could be the ones that are driving the prices,” said Christopher Philips, senior analyst in the investment strategy group at Vanguard, in the article. “Index funds do help investors execute their objectives and their plans, but they’re not responsible for the macroeconomic environment that we’re seeing.”
“For whatever reason, everything in the market that goes wrong appears to be blamed on ETFs, but it’s my view that an ETF is just a vehicle; it’s how people use it,” added Tony Davidow, managing director and portfolio strategist at Guggenheim Investments, in the report.