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Thoughts on the stock correlation debate

ETFs have become an influencing force for stock returns
By Imran Ahmed constituents of the Russell 2000 index, ETF trading volume generated more than 60% of their trading volume. Large capitalisation stocks are not entirely immune, 23% of volume in one Standard and Poors 500 index member (FTI) is attributed to ETF trades.7 Clearly, there is a feedback loop between specific stocks and ETFs. Moreover, it seems the less liquid a stock the greater the possible impact upon it by being an ETF constituent. Arguably, for extremely liquid stocks correlation with index returns seems not to have

t the end of 2011, global stock market capitalisation of member exchanges of the World Federation of Exchanges stood at US$47.4 trillion. 1 By contrast, the exchange traded funds (ETFs)2 industry ended 2011 with assets of around US$1.1 trillion or 2.3% of global market capitalisation.3 The proportion of ETFs to market capitalisation improves slightly if one narrows the parameters exclusively to US equity ETFs and the New York Stock Exchange / NASDAQ. The two main US stock markets ended 2011 with a market capitalisation of US$15.6 trillion while US equity ETF assets totalled US$508 billion (3.3% of total market capitalisation).4 Nevertheless, even at a paltry 3% of market capitalisation, the ETF industry is cause for much consternation amongst regulators, investors and also academics. Regulators fret about systemic risks posed by ETFs. Investors seek to generate alpha through ETFs. Academics, as is their wont, seek to understand all aspects of ETFs: a security which has rapidly become an integral part of the capital markets over the last two decades. Undoubtedly, buying an entire portfolio of stocks is less risky than buying a small number of individual securities. That idea helped popularise the mutual fund. More recently, the concept of diversification is a core notion behind the increased prominence of the mutual funds cheaper cousin: the ETF. However, according to the Capital Asset Pricing Model (CAPM) a securitys return is directly related to risk. The greater the risk, the higher the expected return (and vice versa). Controversy about the efficacy about the CAPM theory remains rife. Nonetheless, one fact is clear: until a better alternative appears, CAPM will continue to dominate investor behaviour and, therefore, portfolio construction. So, with ETFs becoming a more important part of investor portfolios, what, if any, is the relationship between ETFs and individual stocks contained in their underlying index?

ETFs may hold only a small fraction of assets relative to mutual funds but their impact on daily stock trading is far from trivial. Unlike mutual funds, ETFs are more regularly traded. In 2011, the World Federation of Exchanges recorded ETF turnover value at US$10.3 trillion, a growth of almost 8% over 2010.5 In fact, some ETFs have become the security of choice for high frequency traders or traders who transact large volume orders at extremely fast speeds. Some analysts suggest high frequency trading orders now account for approximately 50% of all

The concept of diversification is a core notion behind the increased prominence of the mutual funds cheaper cousin: the ETF
exchange trading volumes.6 This is mainly because many of the most popular stock ETFs employ full replication strategies, i.e. the ETF buys all the stocks in the same proportion as in the index the ETF is designed to track. affected absolute performance despite the explosion of index linked ETFs. International Business Machines (IBM) and Exxon Corporation (XOM) are members of both the Dow Jones Industrial Average and the Standard and Poors 500 Index. Both indices have large and active ETFs, DIA and SPY, with assets of US$12 andUS$ 99 billion respectively. With 2011 returns of 25% (IBM) and 16% (XOM), these two stocks deviated from the return of the Dow Jones Industrial Average and S and P 500 indices by at least 20% and 10% respectively.8 A similar example from a popular sector ETF, the US$7.6 billion SPDR Select Sector Fund Energy (XLE) supports the point. XLEs top three holdings, (Exxon, Chevron and Schlumberger) aggregate approximately 40% of XLEs assets. Yet, there is a wide variation in the ETFs oneyear negative return of almost 2%t versus returns of 6.3, 12.1 and -14.5% for XLEs top three holdings.9 Due to their popularity, ETFs have become an influencing force for stock returns in the modern world. The more popular ETFs tend to be heavily traded
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Proof in the pudding

A recent Goldman Sachs study provided statistics which concludes that ETFs have increased correlation amongst stocks, especially within specific industry sectors. Increased correlations between stocks reduce the opportunity to generate stock specific returns as stock returns gravitate towards a central sector return. The study revealed there is a general trend apparent amongst companies in the same industry sector classification to be more highly correlated. The tendency is particularly visible in sectors with active ETFs. In these sectors individual stocks showed a higher correlation in 2011 than during the financial crisis of 2008-9. Further, the report suggests ETF trading has had an even more pronounced effect on small capitalisation stocks. For three

Insight
SPDR Select Sector Fund Energy (XLE)*
Security XLE XOM CVX SLB
* Month end January 2012 Source: Yahoo! Finance

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One Year Return -1.9% 6.3% 12.1% -14.5%

XLE Holding n/a 18.6% 14.4% 7.2%

and their full replication strategy forces ETF trading to flow through into its underlying stock constituents. For some stocks, trading created by ETFs is a considerable portion of its overall trading volume. A recent study indicated that ETFs have resulted in increased correlation of returns between stocks and indices, especially at the industry level. Nevertheless, despite increased correlation there remains much evidence showing that at the single stock level

absolute returns provide substantial opportunities for managers to generate excess returns over index benchmarks. ETFs are innovative, low cost vehicles for obtaining index returns. But for index beating returns managers are better off brushing up old fashioned stock selection skills and creating customised stock portfolios.
Imran Ahmed is a principal at Deodar Advisors LLP. He can be reached at Imran@deodaradvisors.com

2011 WFE Market Highlights, p.6. January 19, 2012. Published by the World Federation of Exchanges accessed on February 15, 2012. http://www.world-exchanges.org/files/file/stats%20and%20charts/2011%20WFE%20Market%20Highlights.pdf For the purposes of this article, the generic term ETF refers to exchange traded portfolios comprised of various structures, including exchange traded notes (ETNs). ETF Industry Association accessed on February 15, 2012. http://www.etf-ia.com/ ETF Industry Association accessed on February 15, 2012. http://etf-ia.com/sites/all/themes/etfia/downloads/Jan-2012-ETF-Data-Assets.pdf 2011 WFE Market Highlights, p.4. January 19, 2012. Published by the World Federation of Exchanges accessed on February 17, 2012. http://www.world-exchanges.org/files/file/stats%20and%20charts/2011%20WFE%20Market%20Highlights.pdf High Frequency Trading, Investopedia. Accessed on February 17, 2012. http://www.investopedia.com/terms/h/high-frequency-trading.asp#axzz1mcIMpKPI ETF Trades Increasingly Affect Stock Prices by Christopher Condon, Bloomberg. January 7, 2012. Accessed on February 17, 2012. http://www.bloomberg.com/news/2012-01-06/goldman-sachs-sees-correlation-boost-from-etfs-tracking-sectors.html Index returns from Yahoo! Finance. XOM and IBM returns from NASDAQ Omx Global Newswire. Accessed on February 17, 2012. http://www.globenewswire.com/newsroom/news.html?d=241709 All historical stock / ETF data obtained from Yahoo! Finance. Performance calculated based on January 31, 2012 prices.

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Accessing investment opportunities in the Asian titan economies China and India. Whats driving the current ETF traction in China and India and what can we expect going forward?
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