The equity markets have recently been tranquil and very friendly to investors, reaching new highs and registering low volatility. The length of time since a significant decline in the S&P 500 has been unusually long. Just like an extended period of good weather changes our behavior and outlook, the tranquil markets may be related to shifts in investor behavior. Is this a blessing or a curse? It depends on one’s point of view.

Signs Of This Regime Change In The U.S. Stock Market

Signs of the shift in investor behavior are all around us. The attention in the financial press has been focused on the shift from active to passive management, but another even more significant change is occurring under the surface of equity markets—a shift to long-term investing. The tactical, risk-on/risk-off investors that dominated the financial marketplace since the financial crisis are fading into the woodwork. The reverberations of this shift have caught exchanges and some brokers off guard. They are facing reduced commission revenues as trading activity has plummeted. Some high-frequency trading firms have had falling revenue and profits, leading to mergers and exits from the business. Among the beneficiaries of this shift have been public companies who are thrilled to have fewer stockholders focused on short-term earnings and who face less concern that their stock will be whipsawed by trading flows linked to “macro” events. The quieter and slower pace of trading also means that long-horizon investors are seeing less overall market noise (and lower short-term volatility) from tactical flows.

Lower Levels Of Trading Activity

As mentioned above, the two primary signs of a lengthening of investment horizons are lower index volatility and lower levels of trading activity, especially for ETFs. One way to measure how long investors hold equity positions (turnover) is to examine the ratio of the market capitalization or value of all stocks to the amount of daily trading activity. The higher this measure, the longer the holding period, which means the stock of equity capital is not turning over as frequently. This year, stocks have been rising in value, with the S&P 500 and other indexes reaching record highs. At the same time, the average volume of U.S. stocks traded has declined 8 percent (as of the end of September), according to Credit Suisse Trading Strategy based on Bloomberg data,, which means the average holding period for stock positions is increasing and turnover is falling.

Even more significant, ETF trading for the first three quarters of 2017 is down 25 percent from the same point a year ago. Within these ETF trading statistics, we are also seeing a shift away from broad-based U.S. equity ETFs toward more trading in sector, international and fixed-income ETFs (Op. cit.). This sizable slowdown in ETF trading has come in the face of huge inflows into ETFs, with $385 billion of net flows into ETFs through October of this year, over $100 billion higher than the $288 billion of flows in all of 2016, according to ETF.com. These large ETF flows have been coming more from longer-term investors, such as individual investors, financial advisors and registered investment advisors (RIAs), who now represent larger components of the investment community relative to hedge funds and active asset managers. Index managers like Vanguard and BlackRock, popular asset managers for these long-term investors and for 401k plans, have seen their assets swell. 

Lower Volatility

Hedge funds and other short-term tactical investors have long been regular users of ETFs to adjust positions and seek to profit as indexes twist and turn. However, the current market environment is characterized by low levels of realized volatility, as well as expected volatility as reflected in the VIX.  Realized S&P 500 volatility has been very low—6.7 percent year-to-date in 2017—and the VIX has been settling at the low end of its range, below 10 percent on most days. So far this year, only 3.6 percent of trading days have had moves of 1 percent or more. This low level of broad index volatility is both a cause and effect of less tactical and macro-related trading, and its persistence is a strong sign of a regime change to more of a stock pickers market. These conditions have been in place before—more than a decade ago in 2004 through 2006—but since the financial crisis, news of interest rates and global economic developments and macro strategies have dominated. 

Lower Correlations

Lower correlation across stock returns is another sign of a shift to a stock-pickers, bottom-up market, which typically is dominated by stock-based investors with longer horizons. Cross-stock correlation measures the extent to which stocks in an index move together and tends to be highest when more tactical, top-down (macro) investors are dominating flows and price discovery. In a stock-pickers market, price moves are more often based on company fundamentals, reflecting the bottom-up stock focus on the part of investors dominating equity flows. A monthly report provided by S&P Dow Jones Indices shows that as of the end of October, the S&P 500 cross-correlation measure was 0.06 compared to a median level of around 0.35, according to S&P Dow Jones Indexes, Dispersion, Volatility, and Correlation Dashboard, October 2017. Readings of this measure for most months in 2017 have hovered in the range of 0.05 to 0.25, significantly below normal.

The Implications Of This Shift To Longer-Term Investment Horizons

Mostly, this shift is good news for stock issuers who can tilt decision-making to longer-term growth and profit opportunities. They can expect less volatility from news related to short-term earnings and economic and industry factors outside of their control. Strategies like option and volatility selling, which benefit from stable and falling volatility, have moved into favor for their features of income generation as well as their strong returns in this environment. Of course, businesses like exchanges and brokerage firms, whose revenue is driven by high levels of trading activity, have less to be happy about.

Lower Liquidity And Higher Trading Costs

But there is a more troubling implication of this shift to longer investment horizons. The interplay in the equity market between short-term traders and long-term investors is valuable in terms of providing liquidity and keeping trading costs low. When there are many short-horizon investors in the marketplace providing ongoing liquidity, longer-term investors benefit by being able to easily transact when they choose to adjust their positions. In the new regime, this high level of liquidity, helped by the presence of high-frequency trading firms and short-term investors, is threatened and may result in higher trading costs for longer-term position holders when normal volatility levels return. There could also be a feedback loop that further reduces trading activity because of the higher costs, but this is most likely to occur when overall market volatility is higher than it is today.

Macro Events Could Trigger Steeper Declines

Another concern is that the market’s reaction to a major, macro event could be larger in magnitude and duration. With fewer tactical traders standing by to jump in to seize trading opportunities, negative news that impacts a broad group of stocks could lead to a large price impact as long-term investors attempt to reduce equity exposure in the face of greater uncertainly. A lower supply of trading capital from market participants trying to capitalize on short-term moves would mean less flows from tactical traders to step in to buy equities on a sharp down move to attempt to profit from investors’ overreaction.

Eventually, these tactical traders will return if opportunities persist, but the move up in measures like the VIX on a quick market sell-off and the decline in the riskiest, less liquid assets could be greater in the interim. While one would expect long-term investors to be paying less attention to market noise, it has always been surprising how quickly they shift into short-term gear when markets become turbulent, especially to the downside. A portion of the long-term investors may, in fact, become more risk averse and contribute to the sell-off by reducing equity exposure.

Bottom line, this regime shift to longer-term investing is positive from the perspective of stock issuers and for many market participants. However, it comes with some costs and risks—potentially higher trading costs and large price declines when major, unexpected macroeconomic news comes our way.   

Joanne Hill, PhD., is chief advisor of research and strategy at Cboe Vest. Cboe Vest is dedicated to serving investment advisors and brokerage firms in bringing wider access to innovative Target Outcome Investment strategies, including managed account offerings and a series of mutual funds designed to provide greater certainty over risk protection, enhanced returns and consistent income.