Morningstar Advisor - February/March 2012 - (Page 63)

We then calculate the cross-sectional dispersion of volume change as the standard deviation of VCt as measured across all stocks for each time period (t). Exhibit 3 shows the relationship between the cross-sectional dispersion of trading volume changes and the growth in passive equity fund assets, calculated as the percentage of total passive assets relative to the total U.S. stock market capitalization. (We refer to this ratio as the “passive market share.”) The passive market share is linearly interpolated from 1979 to 1993 by reasonably assuming that the percentage of passive assets was zero percent in 1976.3 Our novel results from Exhibit 3 show that the dispersion of cross-sectional volume changes has two distinct regimes: a flat regime from 1979 to 1996 and a persistent declining regime from 1997 to 2010. Further, the second regime declines at an almost constant rate. Exhibit 3 also shows that decline in cross-sectional volume change over time is nearly a perfect inverse of the growth in passive assets. This finding appears highly consistent with our thesis that increased index trading volume drives higher return covariance among an index’s stocks. The systematic decrease in changes in stock volume dispersion over time is consistent empirically and intuitively with the rise in index trading during the same time period. In our study, we use the growth of passive assets as the proxy of index trading. However, index trading can come from a broad range of investment vehicles. For example, high-frequency traders may seek to capture any pricing spread differential between ETFs and index funds. Such common, systematic trading across a basket of stocks would likely contribute to lower dispersion of changes in trading volume. Measuring Pairwise Correlations As we mentioned earlier, trading commonality among index funds and ETFs tends to result in the prices and volumes of constituent stocks moving in the same direction during any given period. Therefore, we would expect to see an increase over time in the average pairwise correlations among both stock prices and trading volumes, especially after the late 1990s (the period associated with rapid growth in passively managed assets). In Exhibit 4, we plot the average of all stock-by-stock correlations for the NYSE/ AMEX/Nasdaq universe of stocks. The figure shows that the equal-weighted average pairwise correlation for both daily price return and trading volume changes increases rather dramatically after 1997. The correlation for each stock is measured on 26 weeks of daily returns and the corresponding volume changes and then averaged across all stocks. As with Exhibit 3, Exhibit 4 also shows that the average pairwise correlations for both price return and change in volume have two distinct regimes: a relatively flat period (from 1980 to 1996) and a sloped period (from 1997 to 2010). Changes in prices and volumes each became meaningfully more pairwise-correlated after 1996. Consistent with our thesis, we suggest that this regime change was in large part a result of increased index trading, which resulted in a significant increase in average pairwise correlations among stock prices and changes in volume. One may argue that the sloped period experienced unusual market turbulence— namely the 2000 technology, media, and telecommunications crash and the 2008 financial crisis—and that these effects might then be responsible for the increased average correlation observed. While correlations across securities and across markets do tend to increase during crashes (in what is known as asymmetrical correlation), there are only about four years (2000–2002, 2007–2009) of the severe downside markets in this period, while the other 10 years experienced more-normal market conditions. So, our findings on the shift in average pairwise correlation suggest meaningful persistent increase from 1997 to 2010, regardless of the status of the market. Impact on Systematic Risk and Portfolio Diversification How does this tie into the steady increase and convergence of U.S. equity betas across size and style? The answer to our question lies, in part, with links to trading commonality driven by index trading. In Exhibit 4, we showed that average pairwise correlations among stocks have increased since 1997. From this, we can reasonably infer that the rise in correlations has simultaneously yielded a rise in average betas. To estimate our betas for Exhibit 1, we use 26 weeks of equal-weighted daily returns and then sort the stocks by size or book/market ratio (for our two style groups). The equalweighted average beta for small stocks is then measured as the average beta for stocks whose market cap is below the 50th percentile of the universe. Likewise, the equal-weighted average beta for growth stocks is the average beta for those stocks whose book/ market ratio is below the 50th percentile of the universe. Strikingly, the observed differences in betas have dramatically narrowed over the past 10 years, as betas for all size and style categories have converged. This convergence comes from the rise of small- and valuestock betas to the same level of large and 3 The Vanguard 500 VFINX, founded in 1976, was the first index mutual fund. MorningstarAdvisor.com 63 http://www.MorningstarAdvisor.com

Table of Contents for the Digital Edition of Morningstar Advisor - February/March 2012

Morningstar Advisor - February/March 2012
Contents
Contributors
Letter From the Editor
Make a Difference Stories, Not Debates
How Concerned Are You About Europe?
Analytical and Independent
What to Ask When a Fund Manager Leaves
Past, Present, Future
Have Financials Gotten Cheap Enough?
Four Picks for the Present
Investment Briefs
Tactical Funds Miss Their Chance
Specialty Retail: Ad Hoc Opportunity
How Europe Is Making Its Crisis Worse
Impact on U.S. Economy Will Be Minimal
European Banks: Bargains or Value Traps?
Don’t Count the Euro Out Yet
Europe on the Brink
GoodHaven Realizes Its Vision
How Index Trading Increases Market Vulnerability
Nonlisted REITS: Handle With Care
Safety Picks for the Many Moods of Mr. Market
On the Prowl for Large- Blend Index-Beaters
Our Favorite Mutual Funds
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
The Math That Matters

Morningstar Advisor - February/March 2012