The Rise of ETFs and Stock Market Correlation

NEW YORK (TheStreet) -- The U.S. market has experienced increased correlation among stocks, which could have serious implications for investors trying to maintain diversified portfolios.

Some experts blame greater market-driving events and the overall state of the economy as reasons for stocks moving more in lockstep. However, an alternative explanation could be the increase in index-based products such as exchange-traded funds.

Index-based products such as ETFs have opened a new area of arbitrage because investors can profit from the price difference between the ETF and its underlying securities.

When engaging in arbitrage, investors are buying up or selling large baskets of securities at the same time and causing them to move together.

For example, if the S&P 500 ETF (SPY) is selling at a premium, an arbitrageur could buy up the components of the S&P 500 and exchange them for ETF shares. However, this transaction would seem to move the components of the S&P 500 in the same direction, increasing their correlation.

Since 2007, trading volume of the 10 most actively traded ETFs has been highly correlated to correlations among stocks measured by the CBOE implied correlation index.

Periods of increased correlation has been preceded by spikes in ETF trading volume, while periods of low trading volume lead to low correlation among stocks, according to data from Barron's and the Chicago Board Options Exchange.

Goldman Sachs found that ETFs have increased correlations among stocks, but have not affected all stocks equally. Only small-cap stocks whose trading volume are driven largely by ETF trading have seen a substantial increase in correlations among the stocks in the ETF. Goldman estimated that 26 companies from the Russell 2000 get at least 20% of their average trading volume from ETFs, and as a result have much higher correlations with each other (80% to 90%).

Although some experts argue that stock correlations depend more on macro events and the state of the overall market, Goldman found that correlations among stocks have continued to increase past their 2008-2009 levels. Sectors have also become correlated with each other, up to 70 percent.¹