What drives last-minute rushes in the stock market?

Traffic isn’t the only place where rush hour strikes. The stock markets experience their own closing frenzy, and neither is born of virtue

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.