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May 1, 2012

ETF Volume, Correlation Down

By James Armstrong

Volumes of exchange-traded funds are down, and many people believe that declines in correlations could be the cause.

According to a recent Credit Suisse report, ETFs made up only 16 percent of overall volume in the first quarter of 2012, down from 19 percent for all of 2011.

The same report found that average correlation across the S&P 500 went as low as 13 percent in February. In 2011, by contrast, correlation surpassed 80 percent in the fall and ended the year at 77 percent for December.

See Chart: Implied Versus Realized Correlation

That is no coincidence, said Ana Avramovic, an analyst at Credit Suisse. She said investors often flock to ETFs in response to high correlations in the markets.

"If correlation is high, then macro fears tend to dominate, and ETFs are a great way to implement macro ideas since they give you exposure to an entire sector or theme with a single product," Avramovic said. "Naturally, as correlations come down, it makes sense that ETF activity would also come down."

Correlation, when applied to stocks, measures how much stocks are trading in lockstep with one another. Realized correlation among stocks shot up during the financial crisis of 2008, from about 40 percent to around 70 percent. It then drifted down before shooting back up again in May of 2010, according to Credit Suisse data.

Kevin Tyrrell, vice president of execution trading at Bank of America Merrill Lynch, said investors tended to trade in and out of ETFs in the wake of the financial crisis of 2008. Now volatility has dampened, they are returning to traditional single-stock investing.

"People are willing to gain exposure directly to specific underlying names," Tyrrell said. "That in turn will result in a bit of a decreased demand for the broader ETFs."

Tyrrell said correlations still have a ways to unwind, and investors could return to index investing if a macro event brings them back.

Oliver Sung, a director at BofA Merrill, said that while ETF volumes are no longer 23 to 24 percent of all trading, as they were at the end of last summer, they are hovering in the 15 to 18 percent range.

In spite of ETF volumes seeming to have stagnated, there has been little let-up in the number of new funds rolled out in recent months.

According to data from Birinyi Associates, 85 new ETFs were added in the first quarter of 2012, bringing the total number of funds up to 1,423. The most active ETFs by volume were index funds, Birinyi found.

Scott Freeze, president of Street One Financial, said even if investors back away somewhat from ETFs tied to the major indexes, they will still use sector funds.

"We have so many more sector products that are out there, and so many different ETFs that are coming out," Freeze said. "People are going to use that instead of going in to buy a single stock."

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