One knock, as overused and inaccurate as it may be, on exchange traded funds is that these instruments have led to increased equity market correlations.
Some market observers point to falling correlations as signs of a health market rally and the long-term sector correlation average in the U.S. is in the 50% to 60% range. The Federal Reserve’s quantitative easing regime has played a role in significantly boosting U.S. correlations.
“The U.S. equity market is up 27.5% before dividends in the last year, and the correlations among the 10 sectors of the S&P 50 0 average 81.8%. Just look at a one year chart of the Utilities (one of the worst performing sectors in the U.S., up just 7.7%) with Industrials (one of the better groups at 34.6%). With the exception of April/May 2013, these disparate groups ebb and flow on page as if they dance to the same tune. Fundamentals tell you this should not be the case. Industrials are global business which rely on large macro forces for marginal revenues; Utilities are stable, largely domestic enterprises whose investor appeal lies in their high dividend payouts,” said Nicholas Colas, chief market strategist at ConvergEx Group, a global brokerage company based in New York, in a note published Tuesday
“The reason that different sectors trade so closely is a function of the market’s singular focus on Federal Reserve monetary policy. Yes, you would have done better overweighting Industrials and easing up on the Utility names in 2013, but in general bad days were bad for both and good days took both higher,” Colas goes on to note.
Correlations are on the rise and there is no debating that. Four months ago, sector correlations hovered in the 70% range. [Rising Correlations Could Threaten Rally]
As of Dec. 6, the 10 S&P 500 sectors as measured by the nine SPDR ETFs and telecom represented by the iShares U.S. Telecommunications ETF (IYZ) show interesting correlation pictures. Seven had correlations to the S&P 500 of 80% or more with IYZ, the Utilities Select Sector SPDR (XLU) and the Consumer Staples Select Sector SPDR (XLP) being the exceptions, according to ConvergEx data.
However, taking on lower correlations not only means playing defense, but also paying up for the privilege of doing so. For example, XLP and XLU are more richly valued, by wide margins, than the Financial Select Sector SPDR (XLF) . [Bank ETFs Just Aren't Getting Any Respect]
Three months ago, five sectors – energy, utilities, staples, telecom and materials – had correlations below 80%. The average return for the five corresponding sector ETFs over that time is 5.1%.
The sector ETFs with higher correlations have performed better over the past 90 days, led by a 10% gain for the Industrial Select Sector SPDR (XLI) . The “laggard” of the group has been XLF with a gain of 6.4% since Sept. 10.
Historical 30-Day Correlations Against S&P 500
Chart Courtesy: ConvergEx Group