How Index Funds Reshape Intraday Market Dynamics

Abstract

The rise of index-tracking funds reshapes stock market dynamics of trading and information aggregation. To minimize tracking errors, index funds tend to execute trades near the market close. As index fund ownership increases, the clustered trading by uninformed indexers enhances underlying stock liquidity preceding the close relative to the daytime average. While informed trades (e.g., short sales) as a result migrate toward the close, we find price informativeness deteriorates. We provide causal evidence by exploiting reconstitutions of the S&P500 and Russell 1000/2000 indexes. Evidence suggests that better liquidity but noisier prices before the close encourage long-term information acquisition.

Keywords: index fund, intraday stock liquidity, price informativeness, informed traders, information acquisition

JEL Classification: G10, G14