How Smart Beta ETFs Affect Stock Volumes, Correlations

How Smart Beta ETFs Affect Stock Volumes, Correlations

by Michael IdeJune 13, 2014, 12:17 pm

Fundamental investors may have to consider how smart beta strategies can impact their own positions


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One of the big challenges facing US banks this year has been the drop in trade volumes even as the market continues to climb and retail investors have regained the confidence in stocks that was lost during the financial crisis. Citigroup Inc. (NYSE:C) and JPMorgan Chase & Co. (NYSE:JPM) have both warned investors to expect a 20% or higher drop in trade revenue, while Charles Schwab Corp (NYSE:SCHW) is reportingrecord volumes.

Smart beta strategies pose a challenge to fundamental investors

The rise of exchange traded funds (ETF), which average about a tenth as much stock turnover as active management, but smart beta strategies in particular (ETFs that don’t simply use market cap weighting) pose a challenge to fundamental investors who now have to take into account the effect that ETFs can have on their own strategies.

Smart beta ETFs can alter stock volumes and correlations

“The rise of smart beta should give fundamental portfolio managers cause for pause,” write Goldman Sachs analysts Robert D. Boroujerdi and Jessica Binder Graham in a June 13 Global Investment Research report. “One need only look at the high intra-sector correlation of utilities as rates move or the recent momentum unwind to appreciate why a quant-lite overlay is increasingly becoming necessary to run money today.”

Goldman Sachs estimates that smart beta products now make up about a quarter of assets invested in US equity ETFs, having increased from $65 billion AUM in 2009 to $355 billion today. This growth can have a big impact on stocks that combine low liquidity with strong representation among certain smart beta strategies.

Rising ETF AUM and falling trade volume exacerbates this effect

Boroujerdi and Graham give the example of Chevron Corporation (NYSE:CVX) and Cincinnati Financial Corporation (NASDAQ:CINF) which each make up about 1.6% of the SPDR S&P Dividend (ETF) (NYSEARCA:SDY) ($13 billion AUM) even though Chevron’s market cap is ten times higher than CINF’s. CINF already has a higher correlation to SDY ETF than Chevron, and anyone thinking about investing in it will have to account for how that can affect its trade volume or correlations with other stocks.

While this effect is already noticeable in certain cases, as with Cincinnati Financial Corporation (NASDAQ:CINF) and SPDR S&P Dividend (ETF) (NYSEARCA:SDY) above, it can only get more pronounced as ETFs and smart beta grow in popularity, not only because they will make up a larger share of total AUM in the US stock market but also because of how ETFs dampen trade volumes.



About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (, the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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