Do ETFs Increase Correlations?

Abstract

Since State Street Global Advisors launched the first exchange-traded fund (ETF) in 1993, the ETF marketplace has grown considerably. In 2011, the global ETF market surpassed $1.5 trillion in assets under management with more than 4,000 funds. Although investors have come to embrace the benefits of ETFs, critics have begun to question whether these products have caused markets to function differently. More specifically, some have associated ETFs with an increase in volatility and correlations within the equity market. It is true that both volatility and correlations have risen over the past few years; however, this trend is consistent with other periods of macroeconomic uncertainty. In fact, the advantages ETFs offer investors may provide the ability to better navigate market environments that exhibit high volatility and correlations.

This article explores the expansion of ETFs and shifts in the macroeconomic environment to test what impact either may have on volatility and correlations. It also studies the potential implications of these hypotheses for alpha generation. The analysis concludes that although macroeconomics has a sizable effect on correlations, the proliferation of ETFs has had only a minor impact.