Download complete issue - IndexUniverse.com

There is a growing body of research noting that return
correlations for individual securities have been
increasing. A recent paper by Sullivan and Xiong [2012]
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 underlying
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
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.
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.
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
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.
If a portfolio does not maintain a constant level of
tracking error (on average), the portfolio effectively
becomes either more active or passive through time. If
the portfolio is becoming less “active” and charging the
same fee, it becomes increasingly unlikely that the portfolio
manager will outperform his or her benchmark. This
is because, in the absence of any active management skill
(which should cancel out in the aggregate, regardless),
the active manager should be expected to underperform
the appropriately selected benchmark by the total fees
of the portfolio. 3 Therefore, in order to outperform the
benchmark, the portfolio manager will need to take on
active risk, thereby deviating from the benchmark.
If individual securities are, in the aggregate, exhibiting
less idiosyncratic risk and the portfolio manager
www.journalofindexes.com March / April 2013
43