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ETFs And The Correlation Conundrum

In this era of previously seldom-used financial market lingo such as "black swans" and "flash crashes," exchange traded products get plenty of blame place on their doorstep for myriad market problems. If you invest in ETFs, but have some kind of aversion to market correlation, then the cascade of reports over the past couple of years blaming ETFs for rising correlations may leave you feeling torn.

First, I'll attempt to simply define market correlation. Using the S&P 500 as the benchmark, a stock or ETF with a correlation of one essentially has a perfect correlation to the broader market. XYZ Corp. goes up 10% in a year and the S&P 500 does the same and we have perfect correlation, excluding fees and commissions. The problem with correlations is that periods of low correlations are a sign of structurally sound markets while high correlations mean the opposite. Hence why there are plenty of doubters regarding the late June/early July rally we just saw: Sector correlations to the S&P 500 were quite high during that move higher.

Regarding ETFs and correlation, at least in my humble opinion, this is a tricky debate. Do ETFs foster more intense market correlation? Probably. Are they are entirely to blame for the phenomenon? No. Here's a great explanation about higher correlations from JPMorgan Equity Derivatives Strategy:

A significant driver of correlation between stocks is the prevailing macroeconomic environment. During periods of high macro uncertainty, stocks prices are largely driven by macro factors such as economic growth, unemployment, interest rate changes, inflation expectations, etc. Therefore, during changes in macroeconomic regimes, stock prices tend to move in unison leading to a high level of correlation.

Sound familiar? Markets hate uncertainty and we live in very uncertain times thanks to Europe's sovereign debt crisis, anemic job growth in the U.S. and emerging markets inflation. All of those factors would exist even if ETFs did not. Put another way, we all know that Greece has extraordinary fiscal problems that have contributed to the high correlations recently. That said, there is not one Greece-specific ETF available to U.S. investors. The correlation conundrum would exist regardless of a Greece ETF being around or not.

Look at correlation on a historical basis, prior to the highs we've seen in 2010 and 2011, the previous high for the phenomenon was 1987 around the time of Black Monday. The first U.S.-listed ETF made its debut in 1993. Correlation proceeded to be fairly benign for most of the 1990s (with a hiccup late in the decade) up until the financial crisis as more and more ETFs were being introduced, as the chart below indicates.

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So I'll give the critics this much and say "Yes, ETFs have contributed to correlation." That said, I'm not convinced the asset class needs to be convicted of a felony when it's hard to prove even a misdemeanor has been committed. Since no one can prove that correlation would fall by 50% or any other substantial number tomorrow if every ETF in the world suddenly disappeared, I'm apt to keep investing in ETFs, correlation or not.


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