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ETFs could cause high correlation

Fund managers have highlighted the growth in exchange traded funds as the possible cause of a high correlation between stocks that make it difficult for long/short equity strategies to perform.

In its latest sector update on the fund of hedge fund sector, S&P Fund Services says directionless markets have created difficult trading conditions for long/short equity managers.

But an even bigger problem has been persistently high levels of correlation between stocks, which began in 2008. This has removed the differentiation that managers rely on to identify stocks for suitable long and short positions.

S&P says that hedge fund manager Permal measured the correlation among stocks in the S&P 500 index and found that the last time it reached the current level of over 80 per cent was for a few days in 1987, at the time of the crash.

Absolute Fund Management chief investment officer Charles Hovenden, one of the managers interviewed by S&P, believes that high correlation between stocks is due to the popularity of ETFs. These buy stocks mainly on the basis of index weighting rather than their ability to generate returns.

S&P says this seems plausible as ETFs and other passive funds buy virtually every stock in an index, causing the prices of these stocks to move together. But the current levels of high correlation could break down, as Hovenden says, due to the cyclical nature of passive investments being preferred relative to active management.

The company says that in periods where active stock selection has worked, market inefficiencies that active managers need are traded away so that it become difficult to generate above-market returns from stock selection. Similarly, if passive investments dominate, this eventually creates good conditions for active managers as indiscriminate price moves give way to market inefficiencies.

Lead analyst Randal Goldsmith says: “Correlation rises and falls, it is not static. From speaking to mangers, we have a bit of evidence of some differentiation between stocks in September.”

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