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Most, Least Passive Ways Of Investing In Equity Getting Increasingly Close To Each Other

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Goldman Sachs has a piece of research out today on ETFs, billed as sort of "ETFs for dummy portfolio managers who need to start understanding them." It's worth a read if you can get it, with a decent overview of questions that it is probably possible to think too hard about, like whether 400% short interest in many big ETFs is worth freaking out about (short answer: nah).

Particularly useful is a cautious but intelligent stab at the question of whether increased correlations are being driven by increased ETF use:

A substantial debate exists among investors about the cause of increased correlation. Namely, are correlations high simply because the environment is dominated by the macro? Or, are they due to the increasing use of index-level products, such as ETFs and futures? And most importantly, how do these forces interact? Given the nature of the cause-and-effect relationship of the two sides of this debate, we find our highest value in becoming more granular in our approach to these questions by specifically focusing our work on sector-based observations rather than index-level ones.

For those who like charts, here are two charts:

The GS team is pretty coy, but if you were so inclined, you could read these charts as telling a not totally unexpected story: (1) correlation is up in every sector because of mostly macro terribleness, eurozone worries, Fed support, whatever, and (2) there's also probably some effect from the increase in ETF volume, but it doesn't seem to be the main event, particularly not in sectors (banks!) where the macro story is super-obvious.

They then get more granular to look at stocks who get a big chunk of their daily trading volume from ETFs. This is a bit of a dark art, because it requires understanding what percentage of ETF buys/sells are ultimately hedged by a dealer buying/selling the underlying stock; the GS team guesses 50-60% depending on the ETF. This leads them to find that the top ETF-impacted S&P 500 stocks, mainly REITs and energy companies, have 10-20% of their volume driven by ETFs; the top small-caps are as much as 50-60% ETF driven. Unsurprisingly having lots of ETF-driven volume increases your correlation to the ETF, though the effects tend to be in the single digit percentage points.

So while this piece does serve to puff ETFs to clients, it also serves as a sort of counter-correlation road map for single-stock investors, pointing them to stocks where ETF impact is the least. But given their ambiguous data, it seems unlikely that "avoid heavily ETF influenced stocks" is a particularly winning strategy for getting out of the correlation rut we seem to be in.

Of course, you can avoid all these highly correlated ETF-infected public markets by taking refuge in private equity, where a team of operational and financial experts pick companies and capital structures to provide outsize returns without any spooky ETF technicals dragging down results. Except, per the Journal:

Today, the buyout business has become downright mundane, and by some measures, less lucrative.

Firms are doing fewer big deals in recent years and lately are running into difficulties selling companies they already own. With debt less available than before the financial crisis and prices for acquisitions up, returns on investments are down. As a result, private-equity bosses are focusing on midsize deals, growing existing businesses and expanding into real estate and other areas, rather than piling on debt for megadeals.

Returns for '04-'08 vintage funds are a bit better than the S&P but outperformance is down and:

Some industry participants worry that returns could drop further. The reason: Firms are flush with nearly $500 billion of investor money, according to Cambridge. Now, these investors are showing signs of overpaying as they try to put it all to work.

In 2011, private-equity firms paid acquisition prices averaging nearly nine times the earnings before interest, taxes, depreciation and amortization, or Ebitda, of target companies. That is up from seven times Ebitda earlier this decade and near the record 9.7 level in 2007, a year where many deals eventually proved disappointments.

It is perhaps a bit puzzling that increasing passivity and correlation in the public markets is coming alongside decreasing outperformance of private equity. You can if you like point to potential feedback between these two things. Rising correlation (and crap returns) among stocks make it harder for institutions to outperform in the public markets, pushing them to throw money at private equity - and thus pushing corrs up, and returns down, in that asset class.

One possibility is that some of the feedback goes the other way. As Goldman points out:

With slowing growth, low interest rates, nearly $400 billion of private equity dry powder (per industry data provider Preqin) and $1.4 trillion of cash on corporate balance sheets (ex-financials), the risk of acquisition to single-name shorts remain high. Given this reality, investors are increasingly implementing negative views with sectors rather than stocks.

$400bn, $500bn, whatevs. The point is that as private equity is swamped with cash and so overpays and underperforms, it's giving away more of its edge to the public markets in the form of takeover premiums. And, while you might think that would reward active stock-picking, it also brutally punishes incorrect short stock-picking. It is perhaps telling that market psychology is now such that the net effect of that private equity cash seems to be to push more investors into ETFs rather than out of them.

Private-Equity Firms Forced to Evolve [WSJ]