Risk-on / risk-off has changed the entire investing landscape. All asset classes move together much more frequently than in the past. Sector and stock diversification is less effective. Geographical diversification is less effective. And asset class diversification is less effective.
Central bank intervention is certainly part of the reason for this altered climate. But the increased use of ETFs is a major factor as well. ETFs have made it much easier for investors to access broad swaths of the market for much cheaper than in the past, and at the click of a button around the world.
FT Alphaville had another illuminating chart last week indicating this market structure shift. The chart, courtesy of the Credit Suisse Trading Strategy Group, splits up volume between ETFs, High Frequency Traders, and Real Money (essentially mutual funds and pension funds):
The split between the 3 groups has changed drastically in the past 5 years. High Frequency Trading now accounts for the majority of intraday volume, but ETFs have maintained a significant portion of the pie. Real Money has pulled away from the market as mutual fund outflows have continued for years.
Mutual fund outflows, though, have been paired with ETF inflows. As a result, more trading that occurs in today’s market occurs through broad-based instruments, and contributes to the risk-on / risk-off environment. The takeaway is that I expect correlations to stay high (correlations between stocks in a sector, correlations between sectors in a market, and correlations between markets across the world), at least much higher than they were in the pre-ETF world.