As the popularity of index-based exchange traded funds grows, correlation between individual securities in sectors and markets is also on the rise.
Many index-based ETFs employ sampling techniques or carve out specific areas of a broader market to provide a general investment theme, and with more investors utilizing the ETF investment vehicle, observers have pointed out that correlation among ETFs’ underlying securities have increased.
Moreover, according to a recent study, correlation is rising among securities outside of an ETF’s underlying basket as well.
“Our model predicts that demand shocks to ETFs and futures lead to stronger price comovement for index stocks and non-index stocks,” Markus Leippold, Lujing Su and Alexandre Ziegler from the University of Zurich said in the paper titled, Do Index Futures and ETFs affect Stock Return Correlations? “Moreover, demand shocks to ETFs have a higher impact on stock return correlations than shocks to futures. We confirm the model predictions by studying the correlation of U.S. stocks after the inception of S&P 500 futures and ETFs. Furthermore, our empirical results suggest that the return comovement induced by index trading is excessive.”
The researchers contend that both S&P ETFs and futures affect index stock correlations, both ETF and futures activity will affect non-index stock correlations and ETFs have a larger impact on correlations than futures.
Additionally, the researchers argued that increased activity in the ETFs and futures market increase stock return correlation as arbitrageurs try to exploit mispricing in the market by acquiring under-priced assets and selling over-priced assets.
However, the study also revealed that correlations of index stocks are more sensitive to changes in index trading activity than non-index securities.
Consequently, the findings suggest that the growing popularity of ETFs may also be making it harder for active managers to generate alpha, writes Michael Ide for ValueWalk.
Looking ahead, the research also indicate that during bull markets, stock investors may continue to see high correlation or lockstep movements in the equities markets as more keep piling into ETFs to capture broad returns. However, this implies that equity correlation could fall and more individual stocks could stand out if demand for broad index-based stock ETFs begin to fall.
For more information on ETFs, visit our ETF 101 category.