Featured faculty: Jiang Wenxi and Yao Chen
Written by Joanne Madrid

Across major global stock markets, a new habit seems to be taking shape. The trading floor stays calm for hours until the last stretch before closing at 4pm. In a sudden rush, stocks change hands at a remarkable pace, as if all the day’s energy has been saved for 10 final minutes. All signs point back to index funds.

“The rise of index funds has fundamentally altered trading dynamics in the equity markets. Stocks that are heavily owned by index funds show more buying and selling right before the market close,” says Yao Chen, an Associate Professor in the Department of Finance at the Chinese University of Hong Kong (CUHK) Business School.

An index fund is an investment that mirrors the performance of a specific collection of securities or an index. For instance, if the S&P 500, a stock index of the 500 largest US companies, rises by one per cent, the S&P 500 index fund aims to rise by the same amount. To achieve this, the fund actually buys and sells the stocks that make up the index in the same proportions.

By simply mirroring an index rather than outperforming it, index funds generally deliver strong performance, making them popular among investors seeking low-cost portfolios. In the US, index funds accounted for 61 per cent of equity investments last year, mostly managed by two asset giants, BlackRock and Vanguard.

Algorithms continuously monitor an index fund’s portfolio relative to the corresponding index. Meanwhile, fund managers oversee the fund and execute trades once per day, right after the market closes. This timing, as it turns out, has reshaped the trading pattern.

In a study titled How index funds reshape intraday market dynamics, Professor Yao and Professor of Finance Jiang Wenxi, along with their PhD student Wu Siyuan, examine how index funds drive the stock rush near the market close. The study also finds that short sellers are increasingly timing their trades during the rush to camouflage themselves.

Save the best for last?

The stock indices fluctuate throughout the day. However, index funds are valued based on how closely they track their corresponding indices, which are calculated using closing prices of the underlying stocks. Trading closer to the closing price reduces the tracking error or gap between the fund’s return and the index’s return.

“The closer the index fund managers execute their trades to the end of the trading day, the lower their tracking error will be,” says Professor Yao.

Having analysed US equity data from 1993 to 2019, the researchers find that in the last five minutes, not only are more stocks available for trading, but the gaps between the highest bid price and the lowest ask price are also smaller. These indicate a highly liquid market, where trading stocks becomes easy, fast, and cost-effective.

“The closer the index fund managers execute their trades to the end of the trading day, the lower their tracking error will be.”

Professor Yao Chen

More liquidity but less information, just noise

More liquidity does not necessarily make stock prices more informative. During the day, stock prices move in response to economic news, earnings reports, global affairs, or other industry developments.

As the bourse winds down, index funds trade to rebalance their portfolios to match their corresponding index, driven by investor inflows or outflows rather than by real performance. Stocks with higher index fund ownership tend to move with overall market trends, creating noise that can overwhelm information about the actual picture of underlying companies.

“Therefore, if the closing price becomes the main target for most trading, causing a high portion of buying and selling to happen right at the end of the trading day, liquidity may dry up during other trading hours of the day,” Professor Yao adds.

Short sellers go with the flow

The liquidity rush benefits short sellers and informed traders. These traders typically have more genuine information about the stocks and the underlying companies, and try to maximise returns by keeping their transactions discreet to avoid tipping others off. Trading during high liquidity allows them to blend in with the crowd.

“Short sellers bet against the stock and strategically wait until the end of the trading day to trade to coincide with the price reveal from the indices. With this, they can hide their intentions and avoid drastically moving the stock price, allowing them to make more profits,” says Professor Yao.

Despite their smart disguise, collective actions by many short sellers still send a signal. The study finds that a notable increase in short sales right before the market closes is a reliable indicator that the stock price will likely fall further in the subsequent trading days. Eventually, the true information about the company’s performance becomes apparent to the market.

Can regulators entangle the rush hour?

To address the last-minute rush, stock exchanges worldwide have offered closing auctions that allow traders to determine a single closing price for each security. Stock exchanges normally set a cutoff time for placing auction orders, e.g., 3.45pm for the NYSE and 3.50pm for NASDAQ, and the closing prices are announced at 4pm.

Not all trading activity occurs through closing auctions. While the study finds that the volume of securities traded through the auction has grown steadily since 2004, it remains insufficient to slow down the last-minute trading rush. Index fund managers participate largely because closing auctions enable them to trade in large quantities at a precise price, but they rely more on regular trading.

The reasons are not only the high auction fee but also the uncertainty in trading execution. If investment flows change after the cutoff time but before the market actually closes, index fund managers can no longer change the orders and bear the risks of tracking errors.

Finally, although the study focuses on US equities, Professor Yao notes that its implications extend beyond borders, as index funds in other major markets operate in similar ways. “For example, Hong Kong indices are also calculated using closing prices of their underlying stocks,” she adds.

The post What drives last-minute rushes in the stock market? first appeared on China Business Knowledge.

By Putro Harnowo, Senior Content Manager, China Business Knowledge @ CUHK

There is a tendency for stocks that have performed well in the past to continue performing well in the short term and vice versa. This pattern is called price momentum, which reflects the idea that past performance can influence future stock movements. In the US stock markets, this price momentum presents in the medium-term range of one to 12 months before it reverses in the long-term range of two to five years.

However, such medium momentum and long-term price reversal are absent in Chinese bourses, despite being the world’s second-largest with more than 4,700 listed stocks. Instead, their stock prices exhibit strong momentum at the daily level, indicating daily price momentum.

“In daily price momentum, stocks in Chinese markets exhibiting strong performance today are likely to maintain this outperformance tomorrow,” says Jiang Wenxi, Associate Professor in the Department of Finance at the Chinese University of Hong Kong (CUHK) Business School. “This momentum persists for one to two days before exhibiting a reversal within a week.”

“The Chinese stock market is predominantly occupied by retail investors and is characterised by frequent influxes of new investors, a common trait among emerging markets.”

Professor Jiang Wenxi

In a research paper titled Daily momentum and new investors in an emerging stock market, Professor Jiang and an Associate Professor in the same department, Gao Zhenyu, along with Xiong Wei A of Shenzhen Stock Exchange and Xiong Wei of Princeton University, tried to cast light on this phenomenon.

“The Chinese stock market is predominantly occupied by retail investors and is characterised by frequent influxes of new investors, a common trait among emerging markets,” says Professor Jiang. “These new investors, possessing limited investment experience, are prone to cognitive biases and susceptible to the emotional impacts of market fluctuations.”

The main voice behind the noise

Professor Jiang and the team analysed daily, weekly, and monthly stock return data from the China Stock Market and Accounting Research database. The sample covers stocks from two major bourses, the Shanghai Stock Exchange and the Shenzhen Stock Exchange, from 2005 to 2019.

A distinct feature in Chinese stock exchanges is the ability to track all trading activities of individual investors across various brokerage firms using national identity documents. The researchers then categorise new investors as those who opened accounts within the past three months and have traded at least one stock.

Those with less and more than three million Chinese yuan investments are grouped as experienced retail investors and large retail investors, respectively. The researchers also track the transactions of mutual funds and other institutional investors with large capital, such as pension funds and insurance companies.

New investors are found to take up only 2 per cent of the market share, yet the most active, with daily turnover rate of 18 per cent, referring to the percentage of total shares that are bought and sold daily. Unfortunately, the monthly net buying by newbies tends to negatively predict stock returns in the following months.

Experienced retail investors share the same fate. The difference is the large number, as these investors hold the most significant part of the trading volume with 65 per cent. “The high trading intensity and poor stock selection make the two groups of new investors and experienced retail investors noise traders in the Chinese stock market,” says Professor Jiang.

After looking at the previous day’s stock performance, the team found that new investors’ trading behaviour has a direct impact on short-term price changes and leads to a decrease in the stock price in the following days. Meanwhile, based on the previous day’s performance, experienced investors’ trading behaviour showed a positive effect on today’s price but a negative effect in the following week and month. In short, both groups are proven to influence daily price momentum and the subsequent price drop.

“It is plausible that some experienced investors barely meet the threshold of possessing three months of trading experience and consequently, exhibit trading patterns akin to those of new investors,” says Professor Jiang.

Numerous news reports have detailed how investors spend excessive time monitoring, deliberating, and trading stocks. However, there is not enough data on how much attention Chinese retail investors are paying to the stock market related to daily price momentum.

The existing literature on investor attention shows that retail investors tend to focus more on the market when stock prices are going up. A further analysis confirmed this and found that new investors are more likely to follow daily price trends when the market is doing well. Their trading activities also have a bigger impact on daily price momentum during times when the market is performing strongly.

Strong investors as the gatekeepers

While new and experienced retail investors make the noise, large retail investors, mutual funds, and other institutional investors demonstrate lower turnover rates and superior stock selection skills. These groups’ monthly net buying tends to serve as a positive predictor of stock returns in the following months.

Large investors’ daily net buying activities are linked to a drop in stock returns on the previous day. When large investors buy stocks based on the previous day’s stock return, it links to a decrease in the stock return on the current day but increases the stock return in the following weeks.

A deeper analysis reveals that mutual funds normally buy stocks that perform well the day before, indicating a momentum trading pattern. Mutual funds that buy stock on the current day based on the performance on the previous day usually lead the stock price to drop on the current day but are linked with the rise of stock return in the following week and month. This shows that, although at first it might seem otherwise, mutual funds balance out the price momentum.

“Taken together, we find that new investors and experienced retail investors significantly contribute to daily price momentum and subsequent price reversal, while large investors, mutual funds, and other institutions counterbalance these price effects,” says Professor Jiang.

Similar trends worldwide

Professor Jiang and the team further explore whether daily momentum is also visible across stock markets worldwide by looking into international stock return data from 1980 to 2023 in DataStream, which covers more than 100,000 stocks from nearly 200 countries.

The team narrowed down its observation to emerging markets like Brazil, Chile, Mainland China, the Czech Republic, Egypt, Greece, India, Indonesia, Israel, Malaysia, Mexico, Pakistan, the Philippines, Poland, Saudi Arabia, South Africa, South Korea, Taiwan, Thailand, Turkey, and Vietnam. They also examined developed markets like Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Hong Kong, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the UK, and the US.

The result found that 14 emerging markets, including Chile, Mainland China, the Czech Republic, Egypt, Greece, Israel, Mexico, Pakistan, Saudi Arabia, South Africa, South Korea, Taiwan, Turkey, and Vietnam, show strong daily momentum patterns. Surprisingly, daily momentum was also found in three developed markets, namely Austria, the Netherlands, and the UK. Many of the above markets show daily momentum patterns during bullish and bearish times, similar to the trend in Mainland China.

“The significant occurrence of daily price momentum in these emerging markets lends weight to the notion of new investors exerting a meaningful influence,” says Professor Jiang. “It’s plausible that the intensified trading activity of these new investors during bullish periods amplifies the observed asymmetric patterns in those emerging markets that display daily momentum effects.”

The post Interpreting price momentums in Chinese stock markets first appeared on China Business Knowledge.

By Zhang Weiming and Zhou Linyu

In recent years, concerns over global warming linked to carbon dioxide (CO2) emissions have drawn increasing attention. On December 12, 2015, 196 signatories adopted a legally binding international treaty on climate change, namely the Paris Agreement. In the U.S., institutional investors are increasingly aware of the relationship between carbon emissions and global warming, and some of them have formed coalitions to tackle climate change such as Climate Action 100+.

Bond mutual funds, the major participant of the corporate bond market, have also become increasingly aware of firms’ carbon emissions. For example, Wells Fargo Asset Management launched a climate transition credit strategy in June 2021 with the intention to decarbonize their fixed-income portfolios. However, little is known about how concerns for carbon emissions affect the trading behaviours of mutual funds in the corporate bond market, which is largely over-the-counter (OTC) and with a larger presence of institutional investors compared to the equity market.

This is the focus of a paper titled Carbon Emissions, Mutual Funds’ Trading, and the Liquidity of Corporate Bonds, which investigates how firms’ carbon emission levels affect the trading behaviours of corporate bond mutual funds, who hold nearly 20 percent of the U.S. corporate bond market, and the liquidity conditions of corporate bonds. The research was conducted by Cao Jie, Associate Professor at The Chinese University of Hong Kong (CUHK) Business School’s Department of Finance; Li Yi, Principal Economist at the U.S. Federal Reserve Board; Zhan Xintong, Professor of Finance at Fudan University; and CUHK Business School PhD students Zhang Weiming and Zhou Linyu.

Herd Mentality

The study found that mutual funds are more likely to display herd mentality in selling corporate bonds, especially if they are issued by firms with high carbon emissions. To illustrate, if there were 100 mutual funds trading in a given quarter, then there would be one more instance of mutual fund herding to sell a high carbon bond compared to other bonds. The magnitude is economically significant. It could explain 7 percent of the standard deviation of mutual funds’ sell herding behaviour.

The relationship between mutual fund sell herding and carbon emissions is likely driven by mutual funds’ concerns for carbon-related redemption and regulatory risks. Specifically, when a mutual fund holds more high carbon bonds, it is more likely to experience investor outflows. Given that investors react to funds’ carbon exposures, mutual fund managers are more likely to prioritize the selling off of bonds issued by high carbon firms to avoid potential redemptions.

To measure the corporate carbon emission performances, the author team used MSCI carbon emission scores from MSCI ESG rating. This study looked at the monthly MSCI carbon emission score in the sample period from January 2007 to December 2019. At the end of each quarter, firms are sorted into three equal groups according to their average MSCI carbon emission scores over the quarter.

In addition, the enhanced Trade Reporting and Compliance Engine (TRACE) and Mergent Fixed Income Securities Database (FISD) databases were employed for the corporate bond transaction and price data. The data on institutional trading of fixed income securities was obtained from Thomson Reuters Lipper eMAXX, which covers over 90% of the bond mutual fund universe. This dataset contains quarter-end security-level corporate bond holdings of institutional investors.

The study was also supplemented by the Center for Research in Security Prices (CRSP) mutual fund database, which provides data for mutual fund characteristics and flows. The final sample contained 1,698 unique mutual funds, holding 27,146 unique corporate bonds from 1,254 unique U.S. public firms.

How Bond Mutual Funds React

The results imply that if a bond is issued by a firm identified as having a high carbon business model, then the sell herding of mutual funds is 0.954-percentage-point higher compared to bonds issued by other firms.

Furthermore, the effect of carbon emission on mutual funds’ sell herding of corporate bonds got amplified, to nearly three times, following the signing of the Paris Agreement, which raised the awareness level of global warming for general investors and directed their attention to risks associated with carbon emissions.

Why do mutual funds display the herding behaviour in selling off high carbon bonds? The study showed that mutual funds with higher fund carbon exposures experience larger outflows, and that the sensitivity of investor flows to the fund’s carbon exposures increased notably after the Paris Agreement. As a result, to attract more inflows, mutual fund managers, especially those for funds with higher flow-carbon sensitivity, would shift their portfolios away from high carbon bonds.

Moreover, the regulatory risks related to environment and climate also matter for mutual funds. They are more likely to sell high carbon bonds in herds if the bonds are issued by firms subject to stricter environmental regulations.

Impact on Corporate Bond Liquidity

The surge in simultaneous selling of high carbon bonds by mutual funds could lead to an impact on bond liquidity, which carries significant implications for both pricing and market stability.

With four common bond illiquidity measures as dependent variables, the study showed that issuing firms’ high carbon emissions could have significantly negative impacts on corporate bond liquidity. The passage of the Paris Agreement also enhanced the adverse effects of carbon emission on corporate bond liquidity.

RELATED ARTICLE

Are Institutional Investors Taking Stock of Climate Change?

The study provided a detailed analysis on the sell herding trading behaviours and the underlying mechanisms for mutual funds against the backdrop of increasing awareness of carbon emissions in the corporate bond market.

One potential reason is that the growing emphasis on global warming by policy makers has introduced carbon-related regulatory risks to assets with high carbon exposures, making mutual funds more likely to reduce their exposures to such risks. The negative effects of firms’ carbon emission on corporate bond liquidity indicates that pricing implications of carbon emissions for the corporate bond market could also be driven by the bonds’ liquidity conditions, rather than by credit risks alone.

The post Is Climate Change Driving Mutual Funds to Dump High Carbon Bonds? first appeared on China Business Knowledge.