Last Updated: 22 November 2023
I’ve never been a fan of the “risk on, risk off” categories used by commentators to describe market activity from one day to the next, finding it a simplistic way of reporting what’s actually happening. But there’s good evidence that investors are increasingly behaving in such a synchronised fashion.
The CBOE implied correlation index on the S&P 500 index of US stocks is a way of measuring the extent to which the 500 shares in the benchmark move together. The higher the correlation index’s level, the more the S&P 500’s constituent stocks are expected to move in the same direction at the same time.
CBOE describes the principle behind the index on its website as follows: “The implied volatility of a single-stock option simply reflects the market’s expectation of the future volatility of that stock’s price returns. Similarly, the implied volatility of an index option reflects the market’s expectation of the future volatility of that index’s price returns. However, index volatility is driven by a combination of two factors: the individual volatilities of index components and the correlation of index component price returns.”
Measure the implied volatility of index options and then strip out the implied volatilities of the options on constituent stocks, and you’re left with the implied correlation component, in other words.
You can see from the late-2008 peak in the implied correlation index that the point of maximum synchronisation between S&P 500 index stocks came during the most intense part (to date) of the financial crisis. All the index stocks moved down (and, on occasion, up) together as the correlation index hit 100.
But you can also see in the chart that there’s been a steady increase in implied correlation since 2007, despite the recovery in the equity markets from their 2009 bottom. In a research report published last October, analysts from JP Morgan’s equity derivatives team measured correlation from further back in time, showing that there’s been a rising trend since 2000. At the turn of the millennium the implied correlation figure between the S&P 500 index’s stocks was around 30 percent. Now we’re seeing levels of around 70-80 percent.
Various commentators have attributed this, with apparently good reason, to the increasing importance of index-based investing (typically via ETFs or futures). More and more people are trading in indices as a whole, rather than picking out individual stocks from within them.
So when you see stories like the one on our US website last week—describing how ETF trading volumes have recently increased to 40 percent of the overall exchange-based activity in equities—you can guess that equity implied correlation has jumped too. In fact it has—CBOE’s website tells us that the January 2012 implied correlation index rose from 59 at the end of July to 77 yesterday.
What does all this mean? First, if one of the touted benefits of ETFs and index funds is that you can gain diversified access to whole areas of the market in a single transaction, rather than having to buy all the constituent stocks individually, it’s clear that you are getting a lot less diversification than you used to when buying a typical index tracker.
But rising implied correlation doesn’t necessarily tarnish all ETFs’ attractiveness. One implication of increased uniformity in the market movements of S&P 500 constituents is that equity market sectors with potentially very different prospects may all be being treated in the same way, creating over- and undervaluations, and thereby investment opportunities. Those using S&P 500 index ETFs may be better off going long (and short) sectors, in other words.
Another index category that might benefit from increased correlations within the main capitalisation-weighted benchmarks might include those using different weighting methodologies, or built on the basis of an investment strategy.
But, overall, a tendency towards increased polarisation among investors is probably a warning sign. Just as the split of many Western European societies into left and right-wing extremist groups during the 1930s presaged a broader conflict ahead, herd-like behaviour in equity markets doesn’t bode well for the stability of the financial system as a whole.