FT Alphaville has made the case about how increased correlations may be linked to ETFs before — albeit in our own inimitable and non-mathematical style.
But here comes a very similar argument, this time from Barclays Capital’s equity research team (with added maths).
As they noted this week:
Correlation, Correlation everywhere, but not a drop to sell…
Equity correlation is close or higher than its high levels scaled during the credit crisis. This has profound implications even for non-derivatives investors in that it indicates that stock-picking skills are less useful in the current environment.
While much of the variation in equity correlation is driven by equity volatility, from a long term perspective it appears to have had a secular increase in value.
Since 2005, equity correlation has had a close relationship with the increased ETF volumes relative to the volumes in the underlying stocks.
Option implied correlation, which has traditionally traded at a premium to realized, is currently trading at a discount which would indicate that the option market is loathe to believe that the current high correlation is likely to persist. However, the fact that long dated implied correlation is also equally high and almost equal to its short dated version appears to provide a conflicting signal.
And looking further into the phenomenon, BarCap find:
An important structural shift in the equity markets over the past few decades has been the advent of index funds as an alternative to actively managed mandates... The remarkable rise in (broad market based) ETFs over the past decade is of course another manifestation of the same phenomena. Since the dominance of this kind of index-based component in the equity fund flows should logically lead to an increase in equity correlation, it is tempting to theorize that the secular shift in equity correlation documented above is driven by this effect.
They go further still though. Like us, they draw a clear link between ETFs and high-frequency trading, which they suggest is influencing volume flows in the underlying securities. In fact, as they observe:
Given the paucity of data around high frequency equity index fund flows, we choose to rely on ETF traded volumes as a proxy. We are of course not concerned with the normal ebbs and flows in traded volumes. In order to capture the excess ETF volume, we calculate the ratio of the value traded in the SPY ETF relative to the value traded in all the constituents of the SPX index.
To the extent that investors are more inclined to trade the market as a whole, this measure of normalised volume should be higher. As shown in Figure 9 this metric steadily increased since 1998 as SPY volume steadily increased. However, since 2005 its variation appears to be very tightly linked to equity correlation.
BarCap’s overall conclusion, meanwhile, is this:
To summarize, in our opinion, while equity correlation continues to be highly dependent on volatility, the rise in indexation has led to a permanent increase in its “base” level. Thus while we do believe that the current high levels of realized and implied correlations are unsustainable, the eventual drop is not likely to be as high as some market participants might expect.
Which means it may take a massive change in market structure for any deviation from current volatility levels to occur.
Full report available in the usual place.
Related links:
Stock picks tough as asset paths correlate - FT
Did Socgen use ETFs to liquidate Kerviel positions? – FT Alphaville
Global correlation makes it harder than ever… – Business Insider
Is someone liquidating GLD? – FT Alphaville