ETFs had $1.2 trillion in assets under management in early 2012 and is one of the fastest growing segments. So it is likely that ETFs continue to accumulate more assets under management and along with that increased impact on underlying asset prices as well.
When shifts happen, some adapt while others fight it . I think one way to check whether a methodology is fighting or floating with this ETF tide is to check for things like - (a) are the new opportunities sparse/decreasing relative to past? (b) does the methodology require lot more complexity to accomplish same thing that in past was simple? and (c) are the profits more harder to come by relative to past? If answer is Yes then I would imagine the methodology and trader are fighting the tide. Please feel free to disagree/comment.
Recently I came across an interesting paper on ETFs and Asset return correlations. Following are some highlights from the paper.
Why ETF's drive the asset correlations?
- ETFs have a greater potential to affect asset correlations than mutual funds for several reasons. First, traditional mutual funds have some leeway on where to invest their money, and must typically keep some cash on hand for redemption. ETFs, on the other hand, are created in units which must contain the appropriate portfolio. Each time a unit is created or destroyed, the stocks in that ETF portfolio potentially trade together.
- The second reason that ETFs can drive correlations is the arbitrage that they make possible between the price of the ETF and the price of the underlying basket of shares. Arbitrageurs are likely to favor ETFs because, unlike mutual funds, they are easy to short and quick to trade. Now when the basket of shares is bought or sold together for arbitrage purposes, this places demand on all of the stocks together, which in turn increases correlations.
- ETFs, by making it easier to trade stocks with similar characteristics for investors, they acerbate co-movement among stocks that share similar characteristics. By similar characteristics, I mean like size based (small cap, large cap...) or style based etc.
- The paper finds that the more an ETF owns the market capitalization of stocks in its portfolio, the more the stocks in that ETF portfolio tend to move together in the subsequent month.
- An ETF's turnover is another strong determining factor in driving the correlated movement of stocks that make up its portfolio.
- Another finding from the paper is the more a stocks market cap is owned by ETF's, the more that stock co-moves with the market in the subsequent month.
- Similarly the weighted average turnover of ETF's that owns the stock is a strong factor in driving the co-moves of the stock with the market.
If you are interested in reading the full paper, following is the link to the academic paper - ETFs and Asset Return Correlations
Wish you all good health and good trading!
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