Index tracking portfolios currently hold more than 29% of US stocks and are projected to top 50% as soon as 2021, according to Moody’s Investor Service. Less conservative projections (Financial Times, pay wall) suggest that passive investors are on track to own 100% - that is to say, everything - by 2030. This idea is implausible for any number of reasons, and of course we do not expect active management to be driven from the street altogether. But the impressive trajectory of passive fund growth reminds us that traders would be remiss in failing to consider how this development fundamentally alters the landscape of the marketplace and impacts their mandate to obtain best execution.
In its simplest form, a trading opportunity occurs when two parties disagree on the current/future value of a security, e.g., a seller thinks the security is fully valued and the buyer considers it undervalued. This basic description, however, is at odds with the notion of passive investing, as indexers buy and sell the same stocks for the same reason, a change in their index benchmark. Critically, because these benchmarks use the official closing price in calculating their value, passive funds typically seek to do most of their trading at the end of the day in order minimize tracking error versus the index benchmark.
Our analysis, using the Abel Noser Solutions Benchmark Universe, shows that the divergence in trade motivation has had an impact on the microstructure of equity markets. In 2017, 21.2% of trading in Russell 1000 names occurred in the last 30 minutes of the trading day, up from 18.7% in 2013. Small cap names have seen an even larger increase, going from 18.5% in 2013 to 21.7% in 2017.
If we narrow the focus, we see that the majority of this shift has occurred in the closing minutes and the auction, as the period from 3:30 to 3:50 is largely unchanged in both large and small cap names.
There are questions of degree to be parsed here, and naturally, how we define “passive” matters quite a bit. In addition to true index funds, we’ve also seen growth in quasi-passive products such as smart beta. The rise of ETF’s focuses additional liquidity on the close, as the daily creation/redemption activity of these instruments is generally traded at/near the close to match the fund’s Net Asset Value (NAV) more closely.
Regardless of how you structure your passive investing taxonomy, the effect has been the steering of even more trading activity toward the end of the trading day, hollowing out liquidity in the period of time between the closing bell and the typically active opening period. What analysts and students of transaction cost analysis have long called the “volume smile” has grown wider and increasingly crooked to the point where “volume smirk” might soon be a more appropriate description.
The cost of this crooked smile is difficult to distinguish from the overall trend of declining trading costs. The Abel Noser Solutions Universe has seen an almost 21% decrease in full day trading costs from 2013 to 2017. But there remains a persistent implementation penalty for accessing liquidly between the open and 3:30. To be clear, we are not advocating trading exclusively in the last minutes of the day. However, we are pointing out that the concentration of liquidity in the last thirty minutes of the day is relatively more efficient than at other parts of the day. Accordingly, traders should be mindful of this trend when balancing their desire to minimize market impact on liquidity-demanding transactions vs. managing the “timing/opportunity risk” associated with waiting until the end of the day.
Furthermore, we would argue that the shift in liquidity and the persistent discrepancy in cost related to timing has brought into question the robotic reliance on the ubiquitous “% of ADV” metrics. There is certainly a case to be made for the restructuring of the volume profiles used by traders and algorithms alike. It also hints at the utility of an Average Daily Volume ex-Close figure – something we will explore further in a future post. In the meantime, with passive investing showing little sign of slowing down, let alone going away, market participants must be mindful of the ever-shifting liquidity landscape in order to preserve alpha and to uphold their commitments to best execution.
Statistics are based on Abel Noser Solutions Universe benchmark data. Abel Noser Solutions is the leading provider of global multi-asset TCA. For details on our peer universe and how we measure execution quality, please contact firstname.lastname@example.org.
Contact us to learn how our powerful end-to-end trading analytics and transaction surveillance platform can provide transparency; and save you money. Email us at email@example.com to get started. Learn more >