With over a trillion dollars of assets under management to date, ETF products are a significant driver of investment prices.

However, while investment markets are already so highly driven by macro-economic policies, the rise of the ETF has also contributed to the increased correlation of investment returns across different asset classes, and therefore made it even more difficult for a careful investor to make a respectable return on the overall market. Because of the way in which market correlations constrain today’s investment markets so heavily, we need to be able to understand how it is that ETF investments are distributing market returns throughout the market, and how we can adapt to that constraint.

ETFs increase asset correlations mainly because of the way in which they are so tightly bound by their portfolio guidelines. For example, while a Mutual Fund is allows a small amount of leeway in their portfolio holdings, and can therefore over or under allocate their positions based on their returns and analysis, ETFs are required to maintain their portfolio holdings in accordance to their investment mandate. The end result is that an ETF must re-balance itself at the end of the trading day.

This means that the fund will need to sell off excessive growth, and average down on losing positions in the portfolio. With so many different funds of varying different sizes, the end result is that the gains from those positions that over-perform are then effectively reduced at the end of the day, while the losses of under-performing securities are also reduced. The effectively makes for a flatter performance across the entire market, but also means that different asset classes will also begin to perform similarly.

What happens when a fund that holds mainly Apple shares needs to sell off its position in Apple to balance out the rest of the portfolio? The grouping of stocks that didn’t actually realize any gains that day will be bought up, and Apple, which performed very well that day, will be pared down. This illustrates how it is that the correlation can create the perception of a performing market, when really it is simply a few positions that are carrying the market higher through ETFs.

The end result of this kind of correlation is two main outcomes: firstly, we’ll see that there is a perceived threat to the markets from the tied responses, because it creates an apparent lack of transparency. In order to combat this lack of transparency, investors start to move into assets that do not trade on an exchange, such as real estate or private equity holdings. The second trend that emerges is an increase in short-term volatility on a daily basis.

Specifically, as ETFs correct their portfolio holdings at the end of the day, a great deal of trading will take place in assets that would not normally have a reason to change in value, or might perhaps be moving in a counter-intuitive direction given the day’s movements.

As ETFs adjust the market prices of securities in accordance to their portfolios, rather than the actual value of the investment, there will come a seemingly sporadic short-term movement in the equity markets at the end of the day that can mislead investors into thinking that there is perhaps something going on with the position itself. While such an adjustment will arguably correct itself over time, it is somewhat stressful to watch a stock rise on good news, and then decline quickly at the end of the day simply because an ETF position needed to adjust its overall holdings.

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