There is a growing body of research noting that return correlations for individual securities have been increasing. A recent paper by Sullivan and Xiong  titled “How Index Trading Increases Market Vulnerability” not only documents this occurrence, but also cites a potential culprit: the increasing popularity of index funds. Since index funds tend to be value-weighted—and therefore trade the same securities in the same relative portion—as index funds gain more assets, more and more securities are being traded in the same way at the same time, regardless of the under-lying attributes of the stocks themselves.
The increasing “commonality” across individual securities doesn’t appear to bode well for active managers, who by definition seek to add value through individual security selection. This paper will provide insight as to how the level of “active” management has been changing in actively managed mutual funds over the last 21 years by reviewing the historical relationship between gross returns and a benchmark based on each fund’s respective Morningstar category. As one might expect, given the increase in individual security correlations, the average mutual fund correlation to its benchmark has increased over the test period, suggesting that active managers are in fact becoming less active.
Here Come The Index Funds
Index investing has exploded over the last two decades, growing at roughly twice the rate of active investments. Of households that owned mutual funds, 31 percent owned at least one index mutual fund in 2010. The Investment Company Institute estimates that 37 percent of all index fund assets were invested in S&P 500 index funds, while 32 percent were tracking some other domestic equity index. About 40 percent of the new money that flowed into index funds was invested in funds indexed to bond indexes, while one-third was directed toward funds indexed to global and international stock indexes, and one-quarter went to funds indexed to domestic stock indexes.
While equity index assets are only 14.5 percent of mutual fund assets, Sullivan and Xiong estimate indexes represent roughly one-third of total fund assets today when factoring in ETF assets. The first ETF, the SPDR S&P 500 ETF (NYSE Arca: SPY), was introduced in January 1993. Significant growth in ETF assets really didn’t start until 2000, though, when there were roughly $66 billion in assets and 100 options; those numbers have grown to more than $1 trillion in assets with more than 1,400 ETFs available. ETF trading has grown from virtually nil in 2000 to now accounting for roughly 30 percent of total dollar trade volume and about 20 percent of total share volume.1
Just as indexing has changed the nature of stock ownership, so too has the rise of institutional investors. The average fraction of a firm’s equity shares held by institutions has grown from 24 percent in 1980 to 44 percent in 2000, and reached 70 percent in 2010.2 In a world where all institutional investors are trading according to their own respective beliefs, this may not be a problem; however, with the rise in indexing, more stocks are being held by institutions that seek to replicate the return of a given index and minimize tracking error.
Since the vast majority of indexes are value-weighted, they tend to hold the same stocks in the same relative portions. Therefore, when an investor buys (or sells) an index that holds one of these securities, the security is bought (sold) in conjunction with the other securities that make up the index, regardless of the relative attractiveness of the stock itself. This creates an increase in “commonality” among stocks, especially those in the more popular “baskets,” such as those in the S&P 500.
Impact On Active Managers
The most obvious impact on actively managed portfolios from increasing individual security correlations would be higher levels of market correlations (i.e., a decrease in the “active” portion of the portfolio). Although this might seem intuitive, it may not necessarily be the case, if (for example) the portfolio manager was trying to maintain some level of tracking error against his or her respective size and style benchmark. If the portfolio manager were to recognize that correlations among individual securities were increasing, he or she could decide to hold fewer stocks or tilt the portfolio more toward certain sectors.