Correlation Among Asset Classes

Reuters article on rising correlation among asset classes and computer-driven trading. Excerpt with my comments at the end. Highlights are mine.

"Correlation among the individual equities in the Standard and Poor’s 500 index has increased to the highest level since 1987, according to research by Birinyi Associates reviewed in the Wall Street Journal. Birinyi Research Director Jeffrey Yale Rubin blames heightened correlation on the increasing popularity of indexing strategies, which he claims have transformed the way the whole market behaves, reducing the dispersion of returns.

Investors increasingly trade in and out of the whole market using broad indices (including exposure offered by exchange-traded funds) rather than picking individual stocks ...

....Increased correlation is not restricted to components of the big equity indices. Significantly heightened correlations are also evident among different commodity futures markets, and between commodities and equities.....

THE RISE OF HFT TRADING

While the correlation research focuses on the impact of {market} indices...it is intersecting with another debate on the impact of high-frequency, algorithmic and computer-driven trading strategies on price formation, liquidity and volatility in equities and derivatives markets.....

IMPACT ON PRICE FORMATION

For supporters, algo/HFT traders are simply displacing traditional market makers as the principal providers of liquidity to financial markets. Supporters claim HFT traders provide liquidity with narrower spreads than used to be available from traditional market makers in the pits, cutting trading costs for other market participants, including commercial hedgers as well as institutional and retail investors.....

For opponents, the liquidity provided by computer-driven trading strategies disappears just when it is most needed, when market conditions get rough, worsening volatility. The similar trading strategies employed by many HFT programmes (such as statistical arbitrage) heighten correlation, ensure trades become crowded, and create a self-destructive liquidation when they go wrong.

Critics focus on unusual market volatility experienced in August 2007 and again during the “flash crash” of May 2010 to show why HFT has increased rather than reduced volatility. The essential similarity among many quant strategies results in trades becoming crowded, and the application of HFT techniques ensures that when they go wrong it results in a disorderly rush for the exits....

.....There has been little thought given to the impact of HFT outside the specialist community, apart from a few lurid stories mostly focused on the issue of flash orders and front-running, and almost no comprehensive statistics and visibility.....

For supporters and critics alike, the next six months will be dominated by a fierce battle to understand and define HFT’s impact of on price formation and volatility, and shape the regulatory response.

Link: Rising Correlation and Computer-driven Trading. Posted origninally on Jul 13, 2010 08:13 EDT

My comment: The rise of ETFs and derivative securities is rapidly transforming investing. Indexing has been around almost since I started in the business. Back then though the ability for most investors to access broad levels of this type of portfolio management were limited to the inefficient and sometimes expensive use of mutual funds. ETFs helped solve that problem. The ability to gain rapid exposure to an asset class by the simple purchase of one security, along with the almost immediate access to information by all investors and the reduced friction in trading (lower commissions and spreads) are also factors leading to this correlation in my opinion.

Finally I believe that another reason for this correlation is ETFs remove the complete "risk of ruin" from the table.  When investing in a stock {or even most bonds for that matter} an investor has to at least consider the possibility that the stock could go to zero. In theory that cannot happen with an ETF. For example investments related to a broad index such as the S&P 500 should be unable to trade to zero. Presumably the underlying value of these assets would render that impossible.

Note I use the term in theory because we cannot know all the possibilities of what can happen. Particularly I can envision a scenario down the road where there are more shares of a very popular index like the SPY than is possible to replicate in ownership by buying percentage shares of all the underlying companies needed. 

But we do know that ETFs were stressed tested during the 2007-09 market meltdown. While ETFs like almost all assets declined substantially in value, as far as I know not a single ETF went to zero or went out of business (note however that some ETFs did lose substantially all of their value and many have since liquidated-either merging with another ETF in the same family or returning the remaining assets to shareholders).

I believe all of these factors have lead to this correlation. I think the confidence that total loss of principal is unlikely gives investor {but especially short term traders} the tools to rapidly gain broad market and sector access and also permits them to trade in larger increments and for shorter periods of time. Thus the convergence.

These factors are one of the primary reasons we place so much emphasis on money flow analysis. We need to get used to this convergence and continue to develop strategies to take advantage of it as this continued correlation is unlikely to change much given how markets are currently accessed and traded.

*Long ETFs related to the S&P 500 in client and personal accounts.  Long SPY in certain client accounts.