Morningstar Advisor - February/March 2012 - (Page 62)

Gray Matters Exhibit 3 Cross-Sectional Dispersion of Trading Volume Change vs. Growth of Passive Assets*: A drop in volume change dispersion accompanies an increase of the index trading. Dispersion of Volume Change 0.8 Volume Change Dispersion (3-year average) Passive Market Share % of U.S. Equity Market 10 0.7 8 managed. The passively managed assets are split up almost evenly, with $619 billion in equity index mutual funds and $605 billion in equity ETFs. As Exhibit 2 shows, passively managed funds represent only about one third of all fund assets, but the average annual growth rate for passive assets during the past 17 years has been about twice that of actively managed assets (26% per year for passive versus 13% per year for active). Measuring Trading Commonality 0.6 6 0.5 4 0.4 2 01/ 82 01/ 84 01/ 86 01/ 88 01/ 90 01/ 92 01/ 94 01/ 96 01/ 98 01/ 00 01/ 02 01/ 04 01/ 06 01/ 08 01/ 10 *Analysis is for U.S. equity market. The volume change dispersion is smoothed by taking a three-year average. Exhibit 4 Average Pairwise Correlation for Price Changes and Volume Changes for All Stocks*: Both pairwise correlations have increased significantly since 1997. 35% 30 25 20 15 10 5 09/ 83 09/ 85 09/ 87 09/ 89 09/ 91 09/ 93 09/ 95 09/ 97 09/ 99 09/ 01 09/ 03 09/ 05 09/ 07 09/ 09 01/ 83 01/ 85 01/ 87 01/ 89 01/ 91 01/ 93 01/ 95 Return Correlation (3 yr avg) 01/ 97 01/ 99 01/ 01 01/ 03 Volume Change Correlation (3 yr avg) 01/ 05 01/ 07 01/ 09 The accelerating growth of passively managed assets places increased demands on indexrelated trading. This index-trading activity, in turn, precipitates higher trading commonality in the cross-section of stocks that make up each index. These basket orders are sometimes spread over a few days or weeks in an effort to minimize the price impact. Buying (or selling) in one period will likely be followed by more buying (or selling) in the next period as the index manager attempts to mitigate market impact by spreading out the required order flow over time. Furthermore, index funds with a similar focus create similar volume changes for many stocks to the extent that their fund holdings overlap. It follows that index-related trading must, at the margin, reduce the cross-sectional dispersion of trading-volume changes. Understanding the market impact of indexrelated trading requires a focus on how such trading affects a change in the volume of stock trading from period to period, rather than in the absolute level of trading volume. We, therefore, focus on examining the impact of the cross-sectional dispersion of trading volume changes on overall market activity. To accomplish this, we first measure the logarithmic change in trading volume from one period to the next, calculated as: VCt  ln V (t) V (t1) *The average pairwise correlation for both returns and volume changes are smoothed by a three-year moving average. Note that the equation is similar to the often-used log price return definition. 62 Morningstar Advisor February/March 2012 9/ 9/ 9/ 9/ 9/ 84 86 88 90 92 9/ 94 9/ 96 9/ 98 9/ 00 9/ 02 9/ 04 9/ 06 9/ 08

Table of Contents for the Digital Edition of Morningstar Advisor - February/March 2012

Morningstar Advisor - February/March 2012
Contents
Contributors
Letter From the Editor
Make a Difference Stories, Not Debates
How Concerned Are You About Europe?
Analytical and Independent
What to Ask When a Fund Manager Leaves
Past, Present, Future
Have Financials Gotten Cheap Enough?
Four Picks for the Present
Investment Briefs
Tactical Funds Miss Their Chance
Specialty Retail: Ad Hoc Opportunity
How Europe Is Making Its Crisis Worse
Impact on U.S. Economy Will Be Minimal
European Banks: Bargains or Value Traps?
Don’t Count the Euro Out Yet
Europe on the Brink
GoodHaven Realizes Its Vision
How Index Trading Increases Market Vulnerability
Nonlisted REITS: Handle With Care
Safety Picks for the Many Moods of Mr. Market
On the Prowl for Large- Blend Index-Beaters
Our Favorite Mutual Funds
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
The Math That Matters

Morningstar Advisor - February/March 2012