The Bottom Line: An early study finds that the increase in index fund trading corresponds to rising correlations among stocks. The authors suggest that these rising correlations increase market risk and make it more difficult for investors to diversify.

The Study: “How Index Trading Increases Market Vulnerability” by Rodney N. Sullivan (of the CFA Institute) and James X. Xiong (at Morningstar Investment Management). Published in the Financial Analysts Journal in the second quarter of 2012.

The Process: The study examines trading of stocks priced between $2 and $1,000 and with a market cap greater than $100 million from 1979 through 2010. The authors begin by examining “trading commonality,” which they measure by calculating the dispersion in volume changes. As dispersion decreases, trading commonality increases.

They then calculate stock-to-stock (“pairwise”) correlations and the correlation between price returns and trading volume (“cross-correlations”), on the theory that these will increase as trading commonality increases

Finally, to study the potential impact on the ability to diversify, Sullivan and Xiong examine how changes in stock betas relate to the increase in index fund assets.

The Findings: The authors find that trading commonality has been increasing since 1997, concurrently with the rise in index trading. Consistent with their thesis, they find that both pairwise and cross-correlations increased over the same period. They note that stock betas have increased and converged in recent years, and that this change appears to be connected to the rise in index investing, with the result that “diversification benefits diminished dramatically” over the period.

The Implication: Sullivan and Xiong conclude that, “The ability of investors to diversify risk by holding an otherwise well-diversified U.S. equity portfolio has markedly decreased in recent decades” More broadly, their results suggest that “the fragility of the U.S. equity market has risen over recent decades.”

The “Research Spotlight” series highlights academic papers that examine the value of active investment management and its role in investor portfolios.