HSFRC Latest Research: U Disappeared: How Index Funds Reshape Intraday Stock Market Dynamics

The U-shaped intraday pattern in stock liquidity, volume, and price volatility is one of the most well-known empirical patterns documented in the microstructure literature. For example, most previous studies found that intraday width of spreads for U.S. stocks are wider immediately after the open and right before the close. A research conducted by HSRFC member Prof. Wenxi Jiang, along with Prof. Chen Yao from the Department of Finance at CUHK Business School, finds that these U-shaped intraday patterns for the U.S. stock market have recently disappeared. Their paper documents and explains the disappearing U-shaped patterns, and explores its implications for the intraday dynamics of stock trading and pricing.

They argue that the rise of index-tracking investment over the past twenty years  is the main reason for the disappearing U-shaped intraday patterns in stock liquidity, volume, and price volatility. To avoid tracking errors, index funds tend to trade near the close. The clustered trading by uninformed indexers near the close improves stock liquidity but deteriorates price informativeness preceding the close. They provide strong evidence supporting these conjectures by taking advantage of an identification strategy based on random switches between the Russell 1000 and 2000 indexes.

Their paper makes two contributions to the market microstructure literature. First, they are the first to document and explain the disappearance of the salient diurnal patterns. Even without writing new models, the disappearance of the U-shaped patterns and the proliferation of indexing, at a minimum, inform us which existing model may fit the current data better. Second, they show that the rise of index funds provides a unified interpretation for the disappearance of all three diurnal patterns. It not only provides an explanation for the shifting patterns, but also generates new predictions on price informativeness and price pressure in the continuous market before the close.

Research paper: U Disappeared: How Index Funds Reshape Intraday Stock Market Dynamics

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