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 Ellis Ng

Going public is a big step for companies intending to raise significant capital, reduce debt, and expand operations. Before taking that path, financial institutions called underwriters are needed to help assess the risk and appropriate price of equities. These institutions normally are investment banks that employ specialists in initial public offerings (IPOs).

However, a 2020 move by the US Securities and Exchange Commission (SEC) to approve rule changes by the New York Stock Exchange and Nasdaq allowed firms to conduct direct listing without underwriters. In a direct listing, a company’s existing shareholders can sell their shares directly to the public without issuing new shares or raising new capital.

This move was propelled by digital music streamer Spotify, which was the first to list directly on the bourse in 2018, followed by the messaging app Slack and the data analytics company Palantir Technologies. After the SEC officially changed the rules, a few have joined the club, including eyewear maker Warby Parker, online game platform Roblox, and crypto exchange Coinbase.

“The new SEC regulations beg for a thorough investigation of the effects of equity underwriting relationships on clients,” says Zhao Meiling, Assistant Professor of Accounting at the School of Accountancy at the Chinese University of Hong Kong (CUHK) Business School.

While direct listings are typically faster and less expensive, the benefits for the market and public may be less obvious, particularly regarding what the underwriters can bring to the table. In a paper titled The role of equity underwriters in shaping corporate disclosure, Professor Zhao, along with Cheng Mei of the University of Arizona and Zhang Yuan of the University of Texas at Dallas, suggests that underwriters provide the edges that extend after the IPO process.

“Our study suggests the important informational role of underwriters beyond the IPO period and could potentially better inform regulation,” says Professor Zhao.

Reflection from the crisis

The 2008 financial crisis served as a natural experiment to test the informational effects of losing an underwriter on corporate information disclosures. The collapse of Lehman Brothers, which had been involved in underwriting since 1899, had immediate and profound effects on companies having underwriting relationships with the fallen firm.

After analysing the various data from Securities Data Corporation from 1998 to 2008 to compare Lehman clients to clients of other similar investment banks, the researchers found that since the collapse, Lehman clients significantly increased the frequency of their earnings forecasts by 13.31 per cent and voluntary SEC filings to update shareholders by 10.19 per cent. Such behaviour was more pronounced for Lehman clients with stronger underwriting relationships or those experiencing negative returns at the time of the collapse.

“Our study suggests the important informational role of underwriters beyond the IPO period and could potentially better inform regulation.”

Professor Zhao Meiling

“Earnings forecasts and voluntary SEC filings are used to measure the companies’ level of voluntary disclosure activities,” says Professor Zhao. “These disclosures are critical to provide insights into a company’s future performance and operational expectations, which are essential for investors making informed decisions.”

The study also found that Lehman clients that did not increase or only made small increases in their voluntary disclosures faced more challenges in trading their stocks after the collapse compared to non-Lehman clients. However, this predicament is significantly attenuated for Lehman clients with substantial increases in their voluntary disclosures, indicating that greater corporate transparency can partially offset the loss of an established relationship.

Coping with the loss of underwriters

Underwriters invest considerable effort in gathering detailed information about their clients to validate and endorse equity issuances. Although their main role is managing securities distribution and promotion, underwriters also build strong relationships with their clients. These connections enable them to gather and share non-public information with current and prospective investors, extending their influence beyond the transactions.

This informational effect is likely to continue beyond IPOs, the researchers argue, and underwriters continue to shape firms’ information environments as information intermediaries. Information environments refer to the context and conditions under which information is created, disseminated, and utilised. So, when an underwriter collapses, as Lehman did, the companies begin to fill the information gap themselves.

The study also shows that companies seem to balance their own voluntary disclosures against the information provided by their underwriters after an IPO. When underwriters offer strong informational benefits, companies tend to reduce their own voluntary disclosures, suggesting that firms consider the value of information from underwriters to be greater than the potential advantages of making additional voluntary disclosures themselves. “Thus, upon losing underwriting relations, firms actively manage their information environments by increasing public disclosures to offset the increase in illiquidity,” Professor Zhao adds.

Is bypassing equity underwriting a good call?

Equity underwriters play important and unique roles during IPO. Not only to reduce information gaps in the market and improve clients’ information environments, but also to provide business insights. “To secure potential future engagement for financing or other brokerage services, equity underwriters continuously meet with top managers of their clients post-IPO to discuss financing needs, business conditions, as well as potential merger and acquisition opportunities,” says Professor Zhao.

The underwriter’s reputation was also found to negatively correlate to the number of voluntary disclosures the client makes. Reputable underwriters help their clients shape their information environments, and companies feel less of a need to disclose information voluntarily if they are partnered with a more reputable underwriter.

Reputable underwriters provide a certification effect for the companies they represent, Professor Zhao argues, enhancing investor confidence and potentially lowering the cost of capital for issuing firms. Given these benefits and the large network of institutional investors the underwriters have, clients may suffer significant value and information loss when the relationship ends.

“The research indicates that the loss of an underwriter is associated with increased information uncertainty and consequently an increase in firms’ voluntary disclosure,” she adds. “Investors can use these findings to better anticipate the changes in firms’ information environment and makeup of where information comes from and thus make more informed decisions.”

The post The risks of losing underwriters in direct listings first appeared on China Business Knowledge.