How popular ETFs distort share prices

Since the 2008 crash, investors seem to have become contrary en masse. During risk-on' periods, they all buy equities and commodities; when it's risk off', they dump shares and raw materials and scramble to buy bonds and the dollar.

When it comes to getting in and out of shares, many prefer to trade the most liquid vehicles available, very often exchange-traded funds (ETFs). These offer diversified exposure in a single trade, removing the need to research and select individual firms. For retail investors this increasingly herd-like preference for certain ETFs has implications for the way shares or bonds in a given benchmark behave. In particular there has been a big increase in internal index correlations over the last ten years, something that probably reflects the growing use of ETFs.

According to researchers from JP Morgan, there's been a steady rise in internal correlations over the last decade for widely tracked indices, such as the S&P 500 and the FTSE 100 (which underpinthe most heavily traded ETFs in New York and London respectively). In 2000, says JP Morgan, only about 30% of the movement of any individual S&P 500 stock's price on a given day was attributable to the behaviour of the index as a whole. Now, say the researchers, that correlation has risen to 70%-80%.

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A report released last week by Goldman Sachs concentrates on the behaviour of stocks within sectors and reaches similar conclusions. Stocks from the banks, industrials and materials sectors are being traded not because of a fundamental interest in the individual firms, but because stocks in those sectors belong to widely traded ETFs, concludes Goldman.

This trend poses some far-reaching questions. For example, is capital being sensibly allocated once the index tail wags the investment dog? And if one of the original selling points of index funds and ETFs was that you could gain a diversified exposure in a single transaction, does this still hold true when correlations are so high? In short, you may be getting less diversification than you used to.

So what to do? The homogeneous behaviour of index stocks boosts the case for stock-picking. For ETF fans, it's a trend that reinforces the point of indices constructed on other criteria such as investment strategy, factor or theme.

Paul Amery edits www.indexuniverse.eu