Study: ETFs Altering Market Fundamentals For Hedge Funds

Date: Thursday, October 28, 2010
Author: Murray Coleman, Barron's

Tight correlations between stocks are making outperformance by hedge fund managers difficult this year, particularly for long/short funds, according to a report Tuesday by industry consultant Hennessee Group.

The report referred to a study on how different types of stocks, or asset classes, have moved in tandem over time. We discussed that study by Birinyi Associates earlier, noting that correlations appeared to put stock selection at an especially high premium given today’s market.

But the Hennessee paper today went on to note another factor contributing to the spike in correlations: increased use of exchange-traded funds.

That’s causing investors to put more value on broad-based sector and macroeconomic influences, according to the Hennessee Group.

“As ETFs have grown in popularity, they are accounting for a larger share of daily stock-trading volume and are contributing to the market being driven more by macro sentiment than fundamentals,”  the report’s authors concluded.

Based on ratings by Standard’s & Poor’s, the report noted that since the beginning of last year, lower-quality stocks have been outperforming

“This can be partly attributed to the use of exchange-traded funds as these passively managed funds buy into and sell out of broad based indices, which leads to erratic moves for the underlying securities, irrespective of fundamentals,” the report said.

Hedge fund managers have found this to be “an increasingly frustrating development as stocks with poor fundamentals continue to outperform as they benefit from investor flows into broad based investment vehicles,” said the report, which included comments from Charles Gradante, Hennessee Group’s co-founder.